MITS

Business School
FD
 TYPES OF RISKS
• Systematic Risk is the probability of the loss associated with the
entire market or segment
• Unsystematic risk: associated with specific industry, segment or
security. This risk can be eliminated through diversification of
portfolio.

• Risks Associated with Derivatives

Market risk
Credit risk
Operational risk
Legal and documentation risk
Cashflow risk
Basis risk
 Market risk
• The risk of losses due to adverse movements
in, as relevant, equity, bond, commodity,
currency and other market prices, indices or
rates or changes in the volatility of these
movements.
 Credit risk

• Credit risk is defined as “the risk of loss if a counterparty

fails to perform its financial obligations to the firm”.

• It “is found in all activities where success depends on

counterparty, issuer or borrower performance.

• It arises any time that funds are extended, committed,

invested or otherwise exposed through actual or implied
contractual agreements, whether reflected on or off
balance sheet.”
 Operational risk
• Operational risk is defined as “the risk of
direct or indirect loss resulting from
inadequate or failed internal processes,
people and systems or from external events”
 Legal and documentation risk
• Legal risk is the risk that an organisation, in
the event of default or dispute, may be unable
to enforce or rely on rights or obligations
arising under contractual arrangements with
its broker or counterparty.
• It includes specific unusual types of legal risk
such as criminal liability and regulatory risk.
 Cashflow risk
• The risk that the organisation will have
insufficient cash to meet regular margin calls
necessary to sustain its position in an
exchange-traded contract (e.g. where short-
dated futures contracts are used to hedge
long-dated OTC transactions or where
additional margin calls are made intra-day).
 Basis risk
• The risk of loss due to a divergence in the difference between two rates
or prices.

• This usually applies where an underlying physical position is hedged

through using exchange traded futures or options contracts which are
not the same as (but may be similar to) the commodity or property
which constitutes the physical position.

• They will therefore be subject to different prices, rates or values which

may change over time and this may have an adverse impact on the
hedging arrangement.

• The same is true where short-dated contracts are used to hedge long-
dated positions.
 Managing Market Risk

• Measurement of market risk :

• Limit Setting
• Reporting and Monitoring
• Independent Price Verification
• Stress Testing and Scenario Analysis
 Managing Market Risk
• Measurement of market risk :
VaR
• Limit Setting
notional, maturity and (VaR) limits;

organisation-wide stress-based limits to supplement VaR limits;

sensitivity-based limits to manage risks within specific market parameters;

trading limits by trader/desk/country/ industry sector and currency.

 Reporting and Monitoring
reasoned description of the profit/loss and trading activity in a given period;

details of the level of operational exceptions

reconciliations of all items in the trade life cycle, including cash, stock, unmatched and
failed trades;

utilisation against limits, giving details of any regulatory or internal limits breached in
the period and action taken;

where appropriate, stress test/scenario result

details of likely future activity, including hedging against any anticipated transactions.
• Independent Price Verification
Policies and procedures should be developed to
identify and correct these errors by comparing
previous sets of market parameters (i.e. closing
prices and rates) to current end of-day market
parameters, investigating the reasons behind
large variations, and taking the appropriate
action
• Stress Testing and Scenario Analysis
t is important that an organization understands the effects on it of
sudden market changes (e.g. in price, volatility, liquidity) that are
outside the norm. It should therefore:

analyze the organization's situation in the event of sudden or

unpredictable market changes;

put in place policies and procedures for reacting to such situations,

including trigger points at which risk must be actively reduced and/or
senior management should become more closely involved
 MANAGING CREDIT RISK
• Credit risk should be controlled by:

• reviewing regularly the brokers and counterparties with whom an organisation

has credit exposure or with which it places, for example, margin monies;

• setting limits on exposures to counterparties and brokers, as appropriate (taking

into account the financial strength, credit worthiness and experience of
brokers/counterparties (as well as such issues as conflicts of interest)), and
monitoring and dealing with credit limit excesses or sudden margin calls caused by
the effect of price movements or by the impact of new transactions;

• an analysis of credit exposures by counterparty taking into account, where

appropriate, marked to market values;

• where appropriate and practicable, using enforceable netting agreements,

collateral offsets and other credit advancement techniques, as appropriate and
where practicable.
 Netting and Collateral
• Netting used in trading, where an investor can offset a
position in one security or currency with another position
either in the same security or another one. The goal in
netting is to offset losses in one position with gains in
another.

• Collateral Agreement means any separate agreement

between Borrower and Lender for the purpose of
establishing replacement reserves for the Mortgaged
Property, establishing a fund to assure the completion
 MANAGING OPERATIONAL RISK
• the introduction and development of new products; > changes in management and/or
the organization's operations;

• the management of third parties, particularly in the context of the outsourcing and
procurement of IT services;

• the development, introduction, security and use (and failure) of automated systems,
particularly in relation to key business processes;

• human resource failures, particularly as regards people-related processes such as

recruitment and training of staff;

• any loss in business continuity due to events such as natural disasters, terrorist acts;

• changes in regulatory and/or legal environment.

• Legal & documentation risk
• Cash flow
 Hedging
• Hedging is a risk management strategy employed to offset
losses in investments.

• The reduction in risk typically results in a reduction in

potential profits.

• Hedging strategies typically involve derivatives, such as

options and futures

• Hedging is not the same as speculating, which involves

assuming more investment risks to earn profits.
 Hedging concept
• The best way to understand hedging is to think of it as insurance.
• When people decide to hedge, they are insuring themselves against a
negative event.

• This doesn't prevent a negative event from happening, but if it does

happen and you're properly hedged, the impact of the event is reduced.

• So, hedging occurs almost everywhere, and we see it every day.

• For example, if you buy homeowner's insurance, you are hedging yourself
against fires, break-ins, or other unforeseen disasters.
 Hedging
• individual investors, and corporations use hedging
techniques to reduce their exposure to various risks.

• In financial markets, however, hedging becomes more

complicated than simply paying an insurance company a
fee every year.

• Hedging against investment risk means strategically using

instruments in the market to offset the risk of any adverse
price movements. In other words, investors hedge one
investment by making another.
• Technically, to hedge you would invest in two securities with negative
correlations.

• Of course, nothing in this world is free, so you still have to pay for this type
of insurance in one form or another.

• So, hedging, for the most part, is a technique not by which you will make
money but by which you can reduce potential loss.

• If the investment you are hedging against makes money, you will have
typically reduced the profit you could have made, and if the investment
loses money, your hedge, if successful, will reduce that loss.
 Disadvantages of hedging
• Every hedge has a cost; so, before you decide to use
hedging, you must ask yourself if the benefits
received from it justify the expense. Remember, the
goal of hedging isn't to make money but to protect
from losses.

• The cost of the hedge, whether it is the cost of an

option or lost profits from being on the wrong side of
a futures contract , cannot be avoided. This is the
price you pay to avoid uncertainty
 Cont….
• We've been comparing hedging to insurance, but we
should emphasize insurance is far more precise. With
insurance, you are completely compensated for your
loss (usually minus a deductible).

• Hedging a portfolio isn't a perfect science and things

can go wrong. Although risk managers are always
aiming for the perfect hedge, it is difficult to achieve in
practice.
 Example hedging
• Ram buys 10000 shares of X Ltd. at Rs.22 and
obtains a complete hedge of shorting 400 Nifties
at Rs.1100 each. Ram closes out his position at
the closing price of the next day at which point
the share of X ltd. has dropped 2% and the nifty
futures has dropped 1.5%. What is the overall
profit/loss of this set of transaction?
Long X Ltd. Share(22*10000 shares) Rs. 220000
--------------------
Short Nifty (1100*400 Nifties) Rs. 4,40000
--------------------
Loss on account of fall in X Ltd. Shares(220000*2%) Rs (4400)
Gain on account of fall in Nifty (440000*1.5%) Rs 6600
--------------------
Net Gain Rs.2200
----------------------
 Cost to carry model in case of shares futures

• The difference between the futures prices and spot prices is

equated by the cost of carry. This measures the storage cost plus
interest that is paid to finance the asset less the income earned
on the asset.
• F=S(1+r x t)-D(1+r1)
• F=Futures Price
• S=Spot Price
• r= Risk free interest rate per annum
• T=time to maturity
• r1= effective risk free rate of interest from dividends date to
futures maturity date.
 Example
• Calculate the price of three month RIL futures, if RIL (FV Rs.10) quotes
Rs.520 on NSE, and the three month futures quotes at Rs.542, and the
one month borrowing rate is given as 15% and the expected annual
dividend is nil p.a payable before expiry.

• Futures price=520+520*0.15*0.25-0
• 539.50

• Fair value of futures less than the actual futures price futures are
overvalued in the market. Hence the arbitragers would sell futures and
buy stock in cash market.
 Cost to carry model in case of commodity futures

• The relationship between future prices and spot prices

reflect only the carrying cost related to storage.(i.e.,
amount to be paid to store commodity, such as
warehousing, insurance obsolescence and loss.
Convenience yield or benefit from holding stock
• F=[S+PVS-PVC] (1+rt)
• F=Future price
• S=Spot Price
• PVS= PV of Storage cost
• PVC=PV of Convenience yield
• t= time to maturity
 Cost to carry model in case of stock index futures

• Value of Stock Index Futures=S[1+(r-dividend

yield) x t]
• Where, S=Value of Stock Index today
 Basis
• Basis can be defined as the spot price minus futures
price
• There will be a different basis for each delivery
month for each contract. The futures price normally
exceeds the spot price
• Basis=S-F
• In a normal market the spot price is less than the
future price & accordingly the basis would be
negative. If the basis is negative
Thank you