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Financial Derivatives: Instruments For Risk Management

The document discusses financial derivatives and instruments for risk management. It begins by providing background on the development of modern finance theory and how models are used to invest trillions of dollars. It then notes that derivatives were initially created for hedging risk but now also serve as important investment tools. The document goes on to define risk and risk management and discusses various types of risks like market, credit, liquidity, operational, legal, and interest rate risk. It advocates applying an "art of approximations" approach to risk management.

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49 views

Financial Derivatives: Instruments For Risk Management

The document discusses financial derivatives and instruments for risk management. It begins by providing background on the development of modern finance theory and how models are used to invest trillions of dollars. It then notes that derivatives were initially created for hedging risk but now also serve as important investment tools. The document goes on to define risk and risk management and discusses various types of risks like market, credit, liquidity, operational, legal, and interest rate risk. It advocates applying an "art of approximations" approach to risk management.

Uploaded by

avitkumar
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Financial Derivatives

Instruments for Risk management

Understanding Risk in the Market


Introduction

The Academic discipline of finance was developed in


the U.S during the forties, fifties and sixties with
pioneering works by Nobel Laureates Tobin,
Markowitz, Modigliani, Miller and others.
Subsequently, a whole range of ideas and models
were developed in the theory of investments-
Markowitz Model, Capital Asset Pricing Model and
Arbitrage Pricing theory are among the major works.
Relying on such theories and models, trillions of
dollars are invested throughout the world.
Derivatives were first devised for hedging risk, later
with the innovation of securitization, it has emerge
as a very important investment and speculation
instrument.
2
Risk and risk mgmt.

• Risk is defined as the uncertainty

surrounding the outcome of a future event

• Risk management is the process by which

various risk exposures are identified,

measured and controlled.

3
State of risk management

4
What it is not?

“Man in white coat syndrome”

5
What it is?

“art of approximations”

6
Interest in risk management is due to

• volatility

7
We live in a risky world
1971 Collapse of Bretton EX rates became flexible
woods and volatile
1973 Oil price shocks Inflation

1987 Black Monday 1 trillion capital shaved

1989 Japanese stock market Nikkei declined from


deflated 39,000 to 17,000 in 3 yrs
1994 Fed incraesed rates 6 Bond market debacle
times consecutively
1997 Asian crisis Emerging markets
became pariahs
2008 as a aftermath of subprime crisis Sensex fell from
21000 point to 8000 points despite no significant change in
fundamentals..
And the saga continues..
Fed rates 1990-05

9
LIBOR 2000-05

LIBOR: London Inter Bank Offer Rate

10
NYMEX crude oil futures Jan 2004-05

                                                                            

11
INR USD 1973-93

12
INR- USD

13
500
1000
1500
2000
2500

0
1/1/2003

3/1/2003

5/1/2003
Nifty 2003-05

7/1/2003

9/1/2003

11/1/2003

1/1/2004

3/1/2004

5/1/2004

7/1/2004

9/1/2004

11/1/2004

1/1/2005
14
Reasons for volatility

• Deregulation
• Globalization

15
Rank the Financial Instrument according to
their corresponding risk..
• Equity Share
• Short Term Bond issued by Government (RBI).
• Short term bond issued by Tata.
• Long term bond issued by Government. (RBI)
• Long term bond issued by ICICI Bank.
• Preference shares issued by BHEL.
• Nifty Future.
• Options on Reliance.

@Himanshu Joshi,JUIT (H.P) 16


Taxonomy of risks

• Market risk
• Credit risk
• Liquidity risk
• Operational risk
• Legal risk
• Interest rate risk

17
Market risk

the risk incurred in trading assets and liabilities


due to changes in interest rates, exchange
rates, and other asset prices
Directional risk – risk of loss due to unfavorable
movement in the direction of u/l asset, exchange
rate, interest rate or index
Volatility risk – risk of loss due to unfavorable
movement in volatility

@Himanshu Joshi,JUIT (H.P) 18


Risk of Debt Securities

• Interest Rate Risk: debt securities, which pay


fixed coupon rates, suffer a price decline when
interest rates go up unexpectedly, because the
stated coupon is inadequate to compensate for the
prevailing higher level of interest rates.

Fixed Prevailing
Income
Interest Rate
Security
Prices In the Market
Risk of Debt Securities

Likewise reinvestment of fixed contractual


coupons becomes risky when market interest rate
decline.

Re- Prevailing
investm Interest Rate
ent Risk In the Market
Credit Risk

• Treasury securities do not carry credit risk.


However there are corporate bonds that carry
significant amount of credit risk: that the issuer
may be unable to service all or some of the
promised obligations due to financial distress,
reorganization, workouts, or bankruptcy.
Liquidity Risk

• Some debt securities may trade in illiquid markets


(few dealers, wide bid-offer spreads, low depth,
and so on).
• Emerging market debt and some high yield debt
fall into this category.
• Liquidity refers to the ease with which a
reasonable size of a security can be transacted in
the market within a short notice, without adverse
price reaction.
Liquidity Risk

• The seller or the buyer will face following:


1. High Transaction costs such as fees and commissions,
2. Bid-offer spreads
3. Market impact costs, which refer to the possibility
that following the placement of a buy (Sell) order the
market makers may increase (Decrease) the prices at
which they are willing to trade.
Contractual Risk

• Debt securities may be callable by the issuer at the


issuer’s option.
• Holders of mortgage loans have the right to prepay their
old mortgages if they can refinance them at a cheaper
rate.
• This implies that prepayment should increase when
mortgage rates in market drop.
• The lender will want to charge a higher interest rate to
account for the fact that he or she is giving the borrower
a valuation option to call away the loans when interest rate
fall in the market.
• This is “call risk” in the mortgages.
• Hence mortgages must trade at a yield higher than similar
non callable treasury debt securities.
Inflation Risk
• Inflation risk is the risk that money obtained in the future will be
worth less than when it is invested, which is almost always the case.
• The real risk is how much this risk will be. On the other hand, it is
possible, in some cases, to take advantage of deflation that occurs
when interest rates rise.
• A good example is when interest rates are rising, newly issued
fixed-income securities start to pay more, while prices of things
that generally require borrowing, such as real estate, start
declining.
• Thus, for instance, one could buy 4 week T-bills as a way to save for
a house or for a down payment. As the T-bills expire, they can be
re-invested at progressively higher rates (while rates are rising).
• In the meantime, real estate prices are falling because it is
becoming more expensive to borrow the money to pay for it. So the
money earned on the T-bills becomes even more valuable than the
interest rate itself suggests when used to purchase real estate.
Event Risk

• Some debt securities may be sensitive to events such


as hostile reorganizations or leveraged buyouts (LBOs).
Such events can lead to a significant price loss.
• In October 1988 RJR Nabisco was taken over through
an LBO. The resulting company took on heavy debt to
finance the takeover. As a result Moody’s rating for
RJR Nabisco’s debt from A1 to B3.
• The prices of RJR Nabisco dropped about 15%, and
yield spread went from about 100 BPS above treasury
to 350 BPS above treasury.
• In corporate debt market this risk is called event risk.
Operational risk

the risk of loss due to errors in processes and


controls
Model risk – risk of loss due to errors in the
financial mathematics or assumptions underlying
a model used for valuation purposes

27
Legal risks

Risk of loss due to legal events

28
What to do with all these?

• “ART” philosophy

– Accept the risk (e.g., self-insure)

– Remove the risk (divest, diversify)

– Transfer the risk (hedging, insurance)

29
Risk Management process

• Risk Identification

• Risk quantification

• Risk monitoring and reporting

30

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