Trading Hedging Risk Management

Trading, Hedging & Risk
Management
Odie Pichappan
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Birds Eye
View
Trading Terminology
Financial Risk & Control
Financial Instruments - Forwards,
Futures, Swaps, Option Call/Put
Black Scholes Option Pricing, The
Greeks
Mark to Market & FASB 133
Matrix Pricing
Regression Model
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Trading Terminology
Front Office
Trading & Marketing
Middle Office
Position & market analysis
Risk measurement
Credit risk management
Back Office
Accounting & reporting
Legal & contract administration
Budgeting, tax & internal auditing
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Financial Risk &

Control
Categories of Financial Risk
Systemic Risk / Catastrophic event
Operational Risk
Market/Systematic Risk
Liquidity Risk
Legal, Compliance, Contract &
Regulation
Credit Risk and more
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Financial
Instruments
Financial instrument are contracts between two
parties with opposite views on the market,
who are willing to exchange certain risks.
Risk mitigation instruments:
Linear Instruments
Forward Contract Physical
Futures Contract NYMEX
Swap Financial
Non-Linear Instruments
Options Call/Put
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Forwards
A private agreement
between buyer and seller
for the future delivery of
a commodity at an
agreed price.
Futures
A standardized, exchangetraded contract to make or
take delivery of a commodity
at an agreed upon place and
point in the future. Futures
contracts are transferable
OTC between parties.
Mostly Physical Delivery
Exchange Traded
Linear Hedging Swaps
Linear Hedging
An agreement by two parties to exchange, or swap,

specified cash flows at specified intervals in the future.
A swap where exchanged cash flows are dependent on
the price of an underlying commodity, interest rate,
currency and equity. This is usually used to hedge against
the price of a commodity.
OTC
10/07/15
Trading, Hedging & Risk Management
Financially Settled
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Commodity
Swap
Swap is an agreement between two parties, called

Counterparties, who exchange future cash flows over a
period of time
Interest Rate Swaps
Commodity Swap
Currency Swaps and more
A commodity producer wishes to fix his income and

would agree to pay the market price to a financial institution,
in return for receiving fixed payments for the commodity.
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Call
Option
An option that gives the buyer the right,
but not
the obligation, to purchase the underlying security

at the strike price on or before the expiration date
People buy calls because they expect the
underlying stock to go up. If the stock does go
up they make a profit either by selling the calls at a
higher price, or by exercising their option
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Put Option
A contract giving the buyer the right, but not the
obligation, to sell the underlying asset at a prespecified price on or before the expiration date
If you own stock and you buy put options tied to that
stock to protect yourself from a fall in the stock
price, you are buying protective puts, which is a
different strategy than buying puts without owning
the underlying asset
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Black Scholes Option Pricing

Model
The Black-Scholes model is used to calculate a theoretical option price OP (ignoring dividends paid during the life of the option) using the five key
determinants of an option's price: stock price, strike price, volatility, time
to expiration, and short-term (risk free) interest rate.
Where:
The variables are:
S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term
returns over one year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function
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Volatility
Volatility most frequently refers to the standard

deviation of the continuously compounded returns
of a financial instrument with a specific time horizon. It is
often used to quantify the risk of the instrument over that
time period.
The volatility that produces the "best fit" for all underlying
option prices on that underlying stock. Implied volatility
is derived by taking actual market prices of options
and working backwards in a theoretical option-pricing
model to find the assumed volatility.
In general, implied volatility increases when the market is bearish and decreases when the market is
bullish. This is due to the common belief that bearish markets are more risky than bullish markets.
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The
Greeks
In mathematical finance, the Greeks are the quantities representing the

sensitivities of derivatives such as options to a change in underlying
parameters on which the value of an instrument or portfolio of financial
instruments is dependent. The name is used because the sensitivities
are often denoted by Greek letters.
Delta is the first derivative of the value, V, of a portfolio of derivative securities on a single underlying instrument, S, with
respect to the underlying instrument's price. Since delta measures sensitivity to a small change in the price of the underlying,
it may be used to construct an instantaneously riskless portfolio consisting only of cash, a position in the underlying
instrument and an offsetting position in any derivative securities on it.
Gamma measures the rate of change in the delta. The is the second derivative of the value function with respect to the
underlying price. Gamma is important because it corrects for the convexity of delta.
Vega, which is not a Greek letter, measures sensitivity to volatility. The vega is the derivative of the option value with respect
to the volatility of the underlying.
Theta, or "time decay," measures sensitivity to the passage of time (see Option time value). The value of an option is made
up of two parts: the intrinsic value (finance) and the extrinsic value (time). The intrinsic value is the amount of money you
would gain if you exercised the option immediately. The time value is the worth of having the option of waiting longer when
deciding to exercise. Even a deeply out of the money put will be worth something as there is some chance the stock price
will fall below the strike.
Rho measures sensitivity to the applicable interest rate. The is the derivative of the option value with respect to the risk
free rate
.
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Mark to Market
(MtM)
Mark-to-market is an accounting methodology
of assigning a value to a position held in a
financial instrument based on the current
market price for the instrument or similar
instruments
For example, the final value of a futures
contract that expires in 9 months will not be
known until it expires. If it is marked to market,
for accounting purposes it is assigned the value
that it would currently fetch in the open market
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FASB 133
Financial Accounting Standards Board, Standards
Number 133
Requires all derivatives marked to market and

listed on the balance sheet as assets or
liabilities, unless they meet criteria for hedge
accounting.
Measure degree of hedge effectiveness. Divide the
cumulative price (cash flow) change for the hedging
instrument by the cumulative price (cash flow)
change of the hedged item that is attributable to
the risk that is being hedged
derivative value / hedge item value
To qualify to high effectiveness above calculation
must be at minimum between 80% to 125%, If not
FASB 133 requires termination of hedge accounting
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Hedge Effectivenes
Correlation ~ -1
Correlation ~ +1
The hedged item and hedging instrument which belongs to a perfect

hedge for balance sheet dates t0 to t3. From t3 to t5 an probably
rather theoretical extreme movement in the market value can be
15
Odie Pichappan
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and from t5 the
market values are concurrent which 15
Odie Pichappan
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Trading, Hedging & Risk