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    Risk Management

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    coolchethan
    Derivatives are financial instruments whose value is derived from an underlying asset such as a stock, bond, commodity, currency, or market index. There are several types of derivatives including forwards, futures, options, and swaps. Derivatives allow participants to hedge risk or speculate on changes in the price of the underlying asset. Key parties in the derivatives market include hedgers who aim to reduce risk, speculators who take on risk for potential profit, and arbitrageurs who seek to profit from price differences.

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    Risk Management

    Uploaded by

    coolchethan
    111 views19 pages
    Derivatives are financial instruments whose value is derived from an underlying asset such as a stock, bond, commodity, currency, or market index. There are several types of derivatives including forwards, futures, options, and swaps. Derivatives allow participants to hedge risk or speculate on changes in the price of the underlying asset. Key parties in the derivatives market include hedgers who aim to reduce risk, speculators who take on risk for potential profit, and arbitrageurs who seek to profit from price differences.

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    Derivatives are financial instruments whose value is derived from an underlying asset such as a stock, bond, commodity, currency, or market index. There are several types of derivatives including forwards, futures, options, and swaps. Derivatives allow participants to hedge risk or speculate on changes in the price of the underlying asset. Key parties in the derivatives market include hedgers who aim to reduce risk, speculators who take on risk for potential profit, and arbitrageurs who seek to profit from price differences.

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    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    111 views19 pages

    Risk Management

    Uploaded by

    coolchethan
    Derivatives are financial instruments whose value is derived from an underlying asset such as a stock, bond, commodity, currency, or market index. There are several types of derivatives including forwards, futures, options, and swaps. Derivatives allow participants to hedge risk or speculate on changes in the price of the underlying asset. Key parties in the derivatives market include hedgers who aim to reduce risk, speculators who take on risk for potential profit, and arbitrageurs who seek to profit from price differences.

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    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

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