Financial Derivatives &

Risk Management
Objectives:
 Understand the risk, its elements and
uncertainty
 To understand nature of risk
 To study different interpretation of risks
 To know about Risk management process &
methods
 To understand the overall objectives of risk
management is to minimize the cost of risk.
 Is
Risk is symbol of Danger

Or

Symbol of Opportunity ?
 It is
symbol of both
Danger & Opportunity
 The only one thing is certain about
Stock Market is…………..
………….. Uncertainty !
“Playing with F & O is injurious to Wealth”

“ You will burn your money in Derivatives, if not done in

a systematic way”

But at the same time ‘It is Money Vending Machine’.

Learn to make money through……

Trade in Derivatives Systematically & Strategically
 Risk Management
Meaning:
“Risk can be defined as the possibility of loss arising
because of uncertainty of outcome of particular
transaction”.
“Risk refers to variability of the actual returns
from the expected returns in terms of cash flows”.
“Risk management seeks to mitigate variability
and expected losses and increase welfare”.
Elements of Certainty and Risk

Certainty: Is the situation where it is

known what will happen and the
happening of an event carries a
100 percent probability.
Risk: Is the situation when there are
a number of specific, probable
outcomes, but it is not certain as to
which one of them will actually
happen.
 Elements of Uncertainty and
Risk….

Uncertainty: Is where even the

probable outcomes are unknown.
It reflects a total lack of knowledge
of what may happen.
The Webster's Dictionary says that ‘
Risk’ is the possibility of something
unpleasant happening or the
chance of encountering loss or
harm.
Nature of risk:
 Important nature of risk is uncertainty.
One cannot predict risk when it will
occur. Its period of occurrence is not
known.
 It relates to theory of probability and it
standards more on guess work rather
than actual.
 Risk exists in any activities when the
decision maker is in a position to assign
probabilities to various outcomes.
 Different Interpretation of
Risk

Risk can be divided into;

1. Pure Risk (PR) and Speculative Risk
(SR):
PR are those in which the outcome tends to
be a loss with no possibility of gain.
Ex: the risk of fire in a godown
SR are those in which there is a possibility
of gain or loss.
Ex: Secondary market
While PR can be insured
SR cannot be insured
Pure risk encompasses risk of loss from (a)
damage to and theft or expropriation of
business assets, (b) legal liability for
injuries to customers and other parties, (c)
workplace injuries to employees, and (d)
obligations assumed by businesses under
employee benefit plans.
Pure risk frequently is managed in part by
the purchase of insurance to finance losses
and reduce risk.
2. Acceptable and Non-acceptable Risk:
While risks are unavoidable in any business the
potential loss may be so minimal. Ex: a loss of
few stationeries in a month is acceptable.
Certain risks are major and those are known as
non-acceptable. Ex. A major financial loss of
Rs.50 crore is non-acceptable risk.
3. Static Risks and Dynamic Risks:
Risks that do not depend on various
scenarios like pure risks are a type
of static risks
Some risks depend on changes in the
economical, political, social and
other scenarios like speculative
risks are a type of dynamic risks.
Risk Management

Risk management is a systematic approach

in identifying, analyzing and controlling
areas or events with the potentials for
causing unwanted change. It is through risk
management that risks to any specific
programmed are assessed and
systematically managed to reduce risk to an
acceptable level.
Types of Risk (Business &
Individuals)

1. Business Risk : Is concerned with

possible reductions in business value
from any source. The business value
include Price risk, Credit risk and Pure
risk.
2. Personal Risk: The risks faced by
individuals and families viz., earnings
risk, medical expense risk, liability
risk, physical asset risk, financial
asset risk.
Risk Management Process
Risk Mgmt. process involves:
1. Identify all significant risks.
2. Evaluate all potential frequency and
severity of losses.
3. Develop and select methods for
managing risk.
4. Implement the risk management
methods chosen.
5. Monitor the performance and suitability
of the risk management methods and
strategies on an ongoing basis.
Risk Management Methods:
Major risk management methods include:
1. Loss control
2. Loss financing
3. Internal risk reduction
Loss control & Internal risk reduction are
commonly involve decisions to invest
resources to reduce expected losses.
Loss financing decisions refer to decisions
about how to pay for losses if they do
occur.
 RM methods contd…..

Loss Control Loss Financing Internal risk

reduction
Reduced level Retention and Diversification
of risky self-insurance
activity
Increased
Insurance
precautions

Hedging

Other
contractual risk
transfers
Objectives
The overall objectives of risk management is
to minimize the cost of risk.
Risk mgmt. seeks to mitigate variability and
expected losses and increase welfare.

Cost of risk:
Components of the cost of risk include;
1. the expected cost of loss,
2. the cost of loss control,
3. the cost of loss financing,
 Cost of risk contd…..

4. the cost internal risk reduction, and

5. the cost of any residual uncertainty that
remains after loss control, loss financing,
and internal risk reduction methods have
been implemented.
In the context of business risk
management, maximizing firm value is
equivalent to minimizing the cost of risk.
 - End -