Risk Management Risk : All business face risks because they operate in a world of uncertainties

Risks

Operating or Business Risk

Event Risk

Price Risk

Credit Risk

Changes in the price of Commodity inputs and outputs

Changes in the price of Financial Increments

Changes in Interest Rate

Changes in Currency Exchange Rate

Risk Management: Refers to the practice of understanding hedging activities using derivatives instruments.

Hedging : The use of financial instruments or of other tools to reduce exposure to a risk factor. In Short, Hedging risk is the process by which a financial manager tries to fix for a future purchase or sale of a given assets.
Derivatives & Financial Derivatives: Financial instruments which value is derived from an underlying asset. The underlying asset may be equity share, currency, commodity, stock market index, weather etc. Types of Derivative Instruments used for Hedging: Forward contracts Future contracts Options contracts Swap contracts

Functions of Derivatives: 1. Price Discovery 2. Risk Transfer 3. Liquidity 4. Acting as a trading catalyst Participants in Derivative Market : 1. Hedgers: are the traders who wish to eliminate the Short Hedge risk of price change Long Hedge 2. Speculators: are those who are willing to take the risk for short term profit 3. Arbitragers : Who trice to capitalize the price difference lie buy in a market when price is low and sell in market where price is high.

An Overview of Derivatives
Value is depends directly on, or is derived from, the value of another security or commodity, called the underlying asset Forward and Futures contracts are agreements between two parties - the buyer agrees to purchase an asset from the seller at a specific date at a price agreed to now Options offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date

Why Do Derivatives Exist?

Assets are traded in the cash or spot market It is sometimes advantageous enter into a transaction now with the exchange of asset and payment at a future time Risk shifting Price formation Investment cost reduction

The Language and Structure of Forward and Futures Markets

Forward contracts are the right and full obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined date (maturity date) and at a predetermined price (contract price)
This is a trade agreement

Futures contracts are similar, but subject to a daily settling-up process

Forward Contracts
Buyer is long, seller is short Contracts are OTC, have negotiable terms, and are not liquid Subject to credit risk or default risk No payments until expiration Agreement may be illiquid

Futures Contracts
Standardized terms Central market (futures exchange) More liquidity Less liquidity risk - initial margin Settlement price - daily marking to market

Options
The Language and Structure of Options Markets
An option contract gives the holder the right-but not the obligation-to conduct a transaction involving an underlying security or commodity at a predetermined future date and at a predetermined price

Options
Buyer has the long position in the contract Seller (writer) has the short position in the contract Buyer and seller are counterparties in the transaction

Options
Option Contract Terms
The exercise price is the price the call buyer will pay to-or the put buyer will receive from-the option seller if the option is exercised

Option Valuation Basics

Intrinsic value represents the value that the buyer could extract from the option if he or she she exercised it immediately The time premium component is simply the difference between the whole option premium and the intrinsic component

Option Trading Markets-options trade both in over-the-counter markets and on exchanges

Options
Option to buy is a call option Option to sell is a put option Option premium - paid for the option Exercise price or strike price - price agreed for purchase or sale Expiration date
European options American options

Options

At the money:
stock price equals exercise price

In-the-money
option has intrinsic value

Out-of-the-money
option has no intrinsic value

Investing With Derivative Securities

Call option
requires up front payment allows but does not require future settlement payment

Forward contract
does not require front-end payment requires future settlement payment

Profits to Buyer of Call Option

3,000 2,500 2,000 Profit from Strategy Exercise Price = $70 Option Price = $6.125

1,500
1,000 500

0
(500) (1,000) 40 50 60 70 80 90
Stock Price at Expiration

100

Profits to Seller of Call Option

1,000 500 0 Profit from Strategy

Exercise Price = $70

Option Price = $6.125

(500)
(1,000) (1,500)

(2,000)
(2,500) (3,000) 40 50 60 70 80 90
Stock Price at Expiration

100

Profits to Buyer of Put Option

3,000 2,500 2,000 Exercise Price = $70 Profit from Strategy

1,500
1,000 500

Option Price

= $2.25

0
(500) (1,000) 40 50 60 70 80 90
Stock Price at Expiration

100

Profits to Seller of Put Option

1,000 500 0 Exercise Price = $70 Profit from Strategy

(500)
(1,000) (1,500)

Option Price

= $2.25

(2,000)
(2,500) (3,000) 40 50 60 70 80 90
Stock Price at Expiration

100

CALL OPTION BUYER Pays the premium Has right to exercise and buy the underlying shares Profits from rising prices Limited loss, potentially unlimited gain PUT OPTION BUYER Pays the premium Has right to exercise and sell the underlying shares

CALL OPTION WRITER (SELLER) Receives the premium Obligation to sell shares, if contract is exercised Profits from falling prices or remains neutral Potentially unlimited loss, limited gain PUT OPTION WRITER (SELLER) Receives the premium Obligation to buy the shares if contract is exercised

Profits from falling prices

Limited loss, potentially unlimited gain

Profits from rising prices or remains neutral

Potentially unlimited loss, limited gain