DERIVATIVES AND RISK MANAGEMENT

The establishment and growth of financial derivatives markets has been major development trend in financial markets over the past thirty-five years. Financial innovation and increased market demand led to a rapid growth of derivatives trading. Development of financial derivatives was speeded up by the globalization of business, the increased volatility of foreign exchange rates, and increasing and fluctuating rates of inflation. WHAT ARE DERIVATIVES? The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. Derivatives are those securities bearing a contractual relation to some underlying asset or rate. With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:- Derivative includes: (a) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; (b) a contract which derives its value from the prices, or index of prices, of underlying securities. FEATURES OF FINANCIAL DERIVATIVES 1. It is a contract: Derivative is defined as the future contract between two parties. It means there must be a contract-binding on the underlying parties and the same to be fulfilled in future. The future period may be short or long depending upon the nature of contract, for example, short term interest rate futures and long term interest rate futures contract. 2. Derives value from underlying asset: Normally, the derivative instruments have the value which is derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of derivatives depends upon the value of underlying instrument and which changes as per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are closely related. 3. Specified obligation: In general, the counter parties have specified obligation under the derivative contract. Obviously, the nature of the obligation would be different as per the type of the instrument of a derivative. For example, the obligation of the counter parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract would be different.

4. Direct or exchange traded: The derivatives contracts can be undertaken directly between the two parties or through the particular exchange like financial futures contracts. The exchange-traded derivatives are quite liquid and have low transaction costs in comparison to tailor-made contracts. Example of ex-change traded derivatives are Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on. 5. Related to notional amount: In general, the financial derivatives are carried off-balance sheet. The size of the derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the payoff. For instance, in the option contract, the potential loss and potential payoff, both may be different from the value of underlying shares, because the payoff of derivative products differs from the payoff that their notional amount might suggest. 6. Delivery of underlying asset not involved: Usually, in derivatives trading, the taking or making of delivery of underlying assets is not involved; rather underlying transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded in respect of underlying assets. 7. May be used as deferred delivery: Derivatives are also known as deferred delivery or deferred payment instrument. It means that it is easier to take short or long position in derivatives in comparison to other assets or securities. Further, it is possible to combine them to match specific, i.e., they are more easily amenable to financial engineering. 8. Secondary market instruments: Derivatives are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the corporate world; however, warrants and convertibles are exception in this respect. 9. Exposure to risk: Although in the market, the standardized, general and exchangetraded derivatives are being increasingly evolved, however, still there are so many privately negotiated customized, over-the-counter (OTC) traded derivatives are in existence. They expose the trading parties to operational risk, counter-party risk and legal risk. Further, there may also be uncertainty about the regulatory status of such derivatives. 10. Off balance sheet item: Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can be used to clear up the balance sheet. For example, a fund manager who is restricted from taking particular currency can buy a structured note whose coupon is tied to the performance of a particular currency pair. ADVANTAGES OF DERIVATIVES: 1. 2. 3. 4. They help in transferring risks from risk adverse people to risk oriented people. They help in the discovery of future as well as current prices. They catalyze entrepreneurial activity. They increase the volume traded in markets because of participation of risk adverse people in greater numbers. 5. They increase savings and investment in the long run.

TYPES OF DERIVATIVE INSTRUMENTS: Derivative contracts are of several types. The most common types are forwards, futures, options and swap. (I) Forward Contracts

A forward contract is an agreement between two parties a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. Forward contracts, sometimes called forward commitments, are very common in everyone life. Any type of contractual agreement that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract. A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. The contract has to be settled by delivery of the asset on expiration date. In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants. Future Contracts

(II)

A futures contract is an agreement between two parties a buyer and a seller to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure. Future contracts evolved out of forward contracts and possess many of the same characteristics. Unlike forward contracts, futures contracts trade on organized exchanges, called future markets. Future contacts also differ from forward contacts in that they are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profits. Financial futures, like commodity futures are contracts to buy or sell, financial aspects at a future date at a specified price. The important features are there for future contracts: Future contracts are traded on organized future exchanges. These are forward contracts traded on organized futures exchanges. Future contracts are standardized contracts in terms of quantity, quality and amount. Margin money is required to be deposited by the buyer or sellers in form of cash or securities. This practice ensures honor of the deal.

In case of future contracts, there is a dairy of opening and closing of position, known as marked to market. The price differences every day are settled through the exchange clearing house. The clearing house pays to the buyer if the price of a futures contract increases on a particular day and similarly seller pays the money to the clearing house. The reverse may happen in case of decrease in price. Options Contracts

(III)

Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. (IV) Swaps

Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps. 1. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency. 2. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. DIFFERENCE 10 Definition: BETWEEN FORWARD CONTRACTS AND FUTURES CONTRACTS

Forward Contract A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at a specified price.

Futures Contract A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. Standardized. Initial margin payment required. Usually used for speculation.

Structure & Purpose:

Customized to customer needs. Usually no initial payment required. Usually used for hedging. Negotiated directly by the buyer and seller

Transaction method:

Quoted and traded on the Exchange

10 Market regulation:

Forward Contract Not regulated

Futures Contract Government regulated market (the Commodity Futures Trading Commission or CFTC is the governing body) Clearing House

Institutional guarantee: Risk: Guarantees:

The contracting parties

High counterparty risk No guarantee of settlement until the date of maturity only the forward price, based on the spot price of the underlying asset is paid

Low counterparty risk Both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses. Future contracts may not necessarily mature by delivery of commodity. Standardized Opposite contract on the exchange.

Contract Maturity: Expiry date: Method of pretermination:

Forward contracts generally delivering the commodity. Depending on the transaction

mature

by

Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty. Depending on the transaction and the requirements of the contracting parties.

Contract size:

Standardized

INTRODUCTION TO ARBITRAGE In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost. For instance, an arbitrage is present when there is the opportunity to instantaneously buy low and sell high.

People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies. Arbitrage is possible when one of three conditions is met: 1. The same asset does not trade at the same price on all markets ("the law of one price"). 2. Two assets with identical cash flows do not trade at the same price. 3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities). RISK MANAGEMENT: Risk management (RM) is the process by which various risk exposures are identified, measured, and controlled. The process of Risk management is as follows: 1. Identify a companys current risk profile and set a target risk profile. 2. Achieve the target risk profile by coordinating resources and executing transactions. 3. Evaluate the altered risk profile. Risk management allows firms to: 1. Have greater debt capacity, which has a larger tax shield of interest payments. 2. Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility. 3. Avoid costs of financial distress. a. Weakened relationships with suppliers. b. Loss of potential customers. c. Distractions to managers. 4. Utilize comparative advantage in hedging relative to hedging ability of investors. 5. Reduce borrowing costs by using interest rate swaps. 6. Minimize negative tax effects due to convexity in tax code. The different types of risks associated with derivative instruments are as follows: 1. Credit Risk: These are the usual risks associated with counterparty default and which must be assessed as part of any financial transaction. However, in India the two major stock exchanges that offer equity derivative products have Settlement / Trade Guarantee Funds that address this risk. 2. Market Risk : These are associated with all market variables that may affect the value of the contract, for e.g. A change in price of the underlying instrument.

3. Operational Risk : These are the risks associated with the general course of business operations and include: a. Settlement Risk arises as a result of the timing differences between when an institution either pays out funds or deliverables assets before receiving assets or payments from a counterparty and it occurs at a specific point in the life of the contract. b. Legal Risk arises when a contract is not legally enforceable, reason being the different laws that may be applicable in different jurisdictions - relevant in case of cross border trades. c. Deficiencies in information, monitoring and control systems, which result in fraud, human error, system failures, management failures etc. Famous examples of these risks are the Nick Lesson case, Barings\' losses in derivatives, Society General\'s debacle etc. 4. Strategic Risk : These risks arise from activities such as: a. Entrepreneurial behavior of traders in financial institutions. b. Misreading client requests. c. Costs getting out of control. d. Trading with inappropriate counterparties. 5. Systemic Risk: This risk manifests itself when there is a large and complex organization of financial positions in the economy. \"Systemic risk\" is said to arise when the failure of one big player or of one clearing corporation somehow puts all other clearing corporations in the economy at risk. At the simplest, suppose that an index arbitrageur is long the index on one exchange and short the futures on another exchange. Such a position generates a mechanism for transmission of failure - the failure of one of the exchanges could possibly influence the other. Systemic risk also appears when very large positions are taken on the OTC derivatives market by any one player. Neither of these scenarios is in the offing in India. Hence it is hard to visualize how exchange traded derivatives could generate systemic risk in India.