chapter 1 derivatives an introduction
DESCRIPTION
pptTRANSCRIPT
CHAPTER 1
DERIVATIVES – AN INTRODUCTION
Derivatives and Risk ManagementBy Rajiv Srivastava
Copyright © Oxford University Press
Risk
Risk can be defined as deviations of the actual results from expected.
Risk can be classified two ways – 1) risk of small losses with frequent occurrence and 2) risk of large losses with infrequent occurrence.
The impact or magnitude of risk is normally estimated from following two factors 1. The probability of an adverse event happening, and 2. In case the event occurs the magnitude of the loss it
can cause.
2
Derivatives and Risk ManagementBy Rajiv Srivastava
Chapter 1 Derivatives – An Introduction
Copyright © Oxford University Press
Managing Risk
The ways to manage risk include attempt to control potential damage, diffuse, diversify and transfer risk to those willing to accept it.
One can manage the risk by transferring it to another party who is willing to assume risk. Insurance company does not do anything to contain the risk per se but assumes risk on your behalf.
Management of risk through derivatives is commonly referred as hedging which enable offsetting of risk emanating from one situation.
3
Derivatives and Risk ManagementBy Rajiv Srivastava
Chapter 1 Derivatives – An Introduction
Copyright © Oxford University Press
Types of Risks
Business risks are characterised by small losses but with high probability
The risk of large losses with small probability is normally referred as event risk.
Event risk is normally managed by insurance. companies and
Business risk is concerned about Changes in prices, Changes exchange rates, and Changes in interest rates.
4
Derivatives and Risk ManagementBy Rajiv Srivastava
Chapter 1 Derivatives – An Introduction
Copyright © Oxford University Press
Derivatives
Three kinds of business risk of price, exchange rate and interest rate can be managed through products that are classified as derivatives.
Derivatives are products that derive their value from some other asset called underlying asset but in other aspects they may remain distinctly different from and independent of the underlying asset.
5
Derivatives and Risk ManagementBy Rajiv Srivastava
Chapter 1 Derivatives – An Introduction
Copyright © Oxford University Press
Derivative Products
Variety of derivatives are available both standard product as well as tailor-made, to suit various applications.
Four broad types of instruments are: Forwards Futures Options, and Swaps,
6
Derivatives and Risk ManagementBy Rajiv Srivastava
Chapter 1 Derivatives – An Introduction
Copyright © Oxford University Press
Classification of Derivatives
The underlying asset can be Commodities Currencies Shares/Indices Interest Rates Credit Weather
Derivatives can be traded either on the exchange or OTC Over-the-counter
(OTC) Exchange Traded
Based on the underlying asset Based on how traded
Chapter 1 Derivatives – An Introduction
7
Derivatives and Risk ManagementBy Rajiv Srivastava
Copyright © Oxford University Press
Participants in Derivative Markets
Hedgers: are those who use derivatives for hedging i.e. reduce or eliminate risk.
Speculators: are those take positions in derivatives to increase returns by assuming increased risk. They provide much needed liquidity to markets.
Arbitrageurs: are those who exploit mispricing in different markets; They assume riskless and profitable positions.
All 3 participants are essential for efficient functioning.
8
Derivatives and Risk ManagementBy Rajiv Srivastava
Chapter 1 Derivatives – An Introduction
Copyright © Oxford University Press
Functions of Derivatives
3 major functions of derivatives are: Enable price discovery Facilitate Transfer of Risk Provide Leverage
9
Derivatives and Risk ManagementBy Rajiv Srivastava
Chapter 1 Derivatives – An Introduction
Copyright © Oxford University Press
Misuses & Criticism of Derivatives
Increased volatility: Though used for efficient price discovery, derivatives when used as a speculative product can make increase volatility in prices.
Increased bankruptcies: Derivatives being leveraged products have caused disproportionate positions leading to several disasters and bankruptcies.
Increased burden of regulations: Most derivatives hide more than they reveal. For financial discipline and better disclosures new rules have to be devised.
10
Derivatives and Risk ManagementBy Rajiv Srivastava
Chapter 1 Derivatives – An Introduction
Copyright © Oxford University Press