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An introduction to risk management

and derivatives

125.220 Semester 2, 2015

Understand the nature and importance of risk

and risk management, especially operational
and financial risk exposures
Examine the fundamentals of futures
contracts
Review the operation of forward exchange
contracts and forward rate agreements
Understand the nature and versatility of
options contracts
Consider the structure of an interest rate
swap and a cross-currency swap

Riskthe possibility or probability of

something occurring that is unexpected or
unanticipated

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Operational risk
Exposure that may impact on the normal commercial
functions of a business, affecting its operational and
financial performance; e.g.:

Categories of risk
Operational risk
Financial risk

technology
property and equipment
personnel
competitors
natural disasters
government policy
suppliers and outsourcing

Can be managed through the use of real options

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Financial risk

Exposures that result in unanticipated changes in

projected cash flows or the structure and value of
balance-sheet assets and liabilities; e.g.:

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Financial risk
Relationships between risks can result in one risk
impacting on another risk

Direct riskthe initial risk event that impacts on the

operational or financial position of an organisation
Consequential risksexposures that eventuate as a
result of an initial direct risk event

interest rate risk

foreign exchange risk
liquidity risk
credit risk
capital risk

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Effective management of risk exposures requires

a structured risk management process

Requires full understanding of the business, including

operations, personnel, competitors, regulators,
legislative requirements, stakeholders, cash flows and
balance sheet structure
Also need to understand interrelationships and causal
links between the above categories

Although the range of risks varies by

organisation, one such model is:

identify operational and financial risk exposures

analyse the impact of the risk exposures
assess the attitude of the organisation to each identified
risk exposure
select appropriate risk management strategies and
products
establish related risk and product controls
implement the risk management strategy
monitor, report, review and audit

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Assess the attitude of the organisation to each

identified risk exposure

Establish related risk and product controls

Ensure adequate controls established, documented
and circulated among personnel
These include procedural controls and system
controls
Procedural controls document risk management
products that can be used by the organisation
System controls cover all electronic product delivery
and information systems relating to the identification,
measurement, management and monitoring of risk
management

An integrated process to analyse the risk management

options available
Generally, several risk management strategies available,
the choice between them to be subject to costbenefit
analysis
All risk management processes and strategies should be
periodically audited

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Select appropriate risk management strategies

and products

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Analyse the impact of the risk exposures

A business impact analysis is used to document each

risk exposure and measure the operational and financial
impacts should the risk event occur
Need to consider both quantitative and qualitative risks

Not all risks will be mitigated or removed

The risks to be avoided, controlled, transferred or
retained should be documented

Identify operational and financial risk exposures

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Implement the risk management strategy

Obtain written authority to proceed with implementation

Check that time lags between the commencement of this
process and the implementation of the strategy have not
impaired the effectiveness of the strategy
Risk strategies are developed for different planning
periods

Monitor, report, review and audit

As risk management is ongoing, the strategies must be

continuously monitored to ensures they achieve the
expected risk management objectives and outcomes

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A derivative is a financial contract which

derives its value from the performance of
another entity such as an asset, index, or
interest rate, called the "underlying".
Derivatives are one of the three main
categories of financial instruments, the other
two being equities (i.e. stocks) and debt (i.e.
bonds and mortgages).

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Derivatives include a variety of financial

contracts, including futures, forwards,
swaps, options, and variations of these
such as caps, floors, collars, and credit
default swaps.
Most derivatives are traded over-thecounter (off-exchange) or on an
exchange such as the Chicago Mercantile
Exchange.

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An agreement between two parties to buy, or

sell, a specified commodity or financial
instrument at a specified date in the future at
a price determined today

A fund manager holding shares who is concerned

the price may fall before they are sold
An investor concerned that share prices may rise
before they are purchased

Most are traded on an exchange

standardised contracts
Removes counter-party risk

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Clearing house - records transactions conducted on

an exchange and facilitates value settlement and
transfer
Initial margin - deposit lodged with clearing house
to cover adverse price movements in a futures
contract
Marked-to-market - the periodic repricing of an
existing contract to reflect current market
valuations
Margin call - the top-up of an initial margin to
cover adverse futures contract price movements

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Hedging involves transferring the risk of

unanticipated changes in prices, interest rates or
exchange rates to another party
The change in the market price of a commodity or
security is offset by a profit or loss on the futures
contract

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Example: A farmer wants to sell wheat in a couple

of months, but is concerned that the price is going
to fall in the mean time.
How can the farmer hedge this price risk?
What does that mean?
How does the farmer protect todays price!

125.220 Semester 2, 2015

Strategy involves carrying out an initial

transaction in the futures market that
corresponds with the transaction to be
conducted in the physical market at a later
date

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Relevant terms

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Examples include:

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Solution

Enter into a wheat futures contract to sell his wheat at a

future date at a price fixed today!
If wheat prices fall, the futures contract will rise in value,
offsetting the loss in the physical market from the fall in
the wheat price
If wheat prices rise, the futures contract will fall in value,
offsetting the gain in the physical market from a rise in
the wheat price

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Although futures contracts are highly standardised,

variations exist between countries, exchanges and
contracts

Margin requirements
Both the buyer (long position) and the seller
(short position) pay an initial margin, held by the
clearing house, rather than the full price of the
contract
Margins are imposed to ensure traders are able to
pay for any losses they incur
Margins create leverage !
e.g. in OMF cTrader Challenge, it is 1:100

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Margin requirements
A contract is marked-to-market on a daily basis
by the clearing house

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Closing out of a contract

Involves entering into an opposite position

i.e. repricing of the contract daily to reflect current

market valuations

Price changes may result in margin calls

require a contract holder to pay a maintenance

margin to top up the initial margin to cover adverse
price movements

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Contract delivery
Most parties to a futures contract:
manage a risk exposure or speculate
do not wish to actually deliver or receive the underlying
commodity/instrument and close out of the contract prior
to delivery date

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Main categories of participants

1. Hedgers
2. Speculators
3. Cash Management
Contrary to text, these are NOT unique
participants:

So most close the position prior to settlement

Traders
Arbitragers

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1.

Hedgers

2.

Attempt to reduce the price risk from exposure to changes

in interest rates, exchange rates and share prices
Take the opposite position to the underlying, exposed
transaction
Example:
An exporter has USD receivable in 90 days. To protect
against falls in USD over the next three months, the
exporter enters into a futures contract to sell USD
Payable he might enter a contract to buy USD

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Speculators

Expose themselves to risk in an attempt to make profit

Enter the market with the expectation that the market price
will move in a direction favourable for them
Example:
Speculators who expect the price of the underlying asset
to rise will go long and those who expect the price to fall
will go short

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3.Cash Management
Suppose a fund manager wants to keep some cash in the
portfolio (for liquidity)
But wants to generate equity returns with that cash.
Equity based futures, e.g. SP500, can get those returns, but
are as liquid as cash.
See example from CREF:

125.220 Semester 2, 2015

Chinese auto importer

Spot rates:
CNY/USD USD/CNY
0.16114

6.2059

On 12 & 13 Aug, Beijing de-valued the currency

on14 Aug: Spot USD/CNY = 6.4003
Sept futures contract 1.5485
Loss on cars: 6,205,900 - 6,400,300

Gain on the short futures position:

on June 10, 2015, agree to buy USD 1 million of

cars in August, but concerned about fluctuations in
the Yuan, particularly down

Sept futures
contract

= 194,400

6,205,900 - 5,912,290
= 293,361

(for 100 yuan)

1.6254

Cars today would be USD 1 mill * 6.2059 =

6,205,900 CNY
implies:
SELL
6205900 / 1.6254

Net 98,961

(Assuming you closed both positions on 14 Aug.)

3,818,076 contracts
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The risks of using the futures markets (for any

purpose) :

E.g. for the SP500, as of Fridays close

1 contract was $522,885

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Margin payments

125.220 Semester 2, 2015

Further cash required if (when?) prices move

adversely (i.e. margin calls)

You might run out of cash before the price turns in

your favour

Basis risk
The difference between the price in the physical
market and the futures market

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Cross-commodity hedging

It may not be possible to find a futures contract in the

exact instrument you need
So, you look for something that *does* have a contract,
which has a high correlation with your instrument
Risk is high correlations are not guaranteed to continue

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A financial instrument designed mainly to

manage specified risks
Offered over the counter by financial institutions

Therefore, more flexible than exchange-traded products

terms and conditions can be negotiated

(recall supposedly low correlation in the sub-prime CDSs)

More flexible, but have counter-party risk

Two main types

1.
2.

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Two types of basis risk

Initial basis
at commencement of a hedging strategy
Final basis
at completion of a hedging strategy

If you cant make a margin call, the position will be

closed and youll get 0.

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Standard contract size

Owing to contract size the physical market
exposure may not exactly match the futures
market exposure, making a perfect hedge
impossible

standard contract size

margin risk
basis risk
cross-commodity hedging

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Forward rate agreements (FRAs)

Forward foreign exchange contracts

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1. Forward rate agreements (FRAs)

An over-the-counter product used to manage

interest rate risk exposures
Allows a borrower to manage future interest rate
risk exposure by locking in an interest rate today
that will apply at a specified future date

Also known as a forward exchange contract; locks

in an exchange rate today for delivery of foreign
currency at a specified future date

Example, an Australian company may be importing

goods from overseas and the company will need to pay
USD1 million in three months time

one party compensates the other, if the reference

rate is different from the agreed rate

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An option gives the buyer the right, but not the

obligation, to buy or sell a specified commodity
or financial instrument at a specified price
(exercise or strike price), on or before a specified
date (expiration date)

125.220 Semester 2, 2015

Call options

Give the option buyer the right to buy the commodity or

instrument at the exercise price
Doing so is called exercising the option

Put options

Give the buyer the right to sell the commodity or instrument

at the exercise price

An option will only be exercised if it is in the

buyers best interests (in the money)

Options can be exercised either:

only on expiration date (European option); or

any time up to expiration date (American option)

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Buyer of a call will not exercise the right to buy if the

physical market price is below the exercise price of the
option contract at expiration date
Buyer of a put will not exercise the right to sell if the
physical market price is above the exercise price of the
option

Types of options

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2. Forward foreign exchange contracts

Premium

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Call option profit and loss payoff profiles

The price paid by an option buyer to the writer

(seller) of the option

Value is determined by:

Exercise price or strike price

The price specified in an options contract at which the

option buyer can buy or sell

Current price of underlying asset (e.g. the stock)

Maturity
Volatility
Interest rate

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Put option profit and loss payoff profiles

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Put option profit and loss payoff profiles

A few more examples from CBOE

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Options differ from futures because they

125.220 Semester 2, 2015

provide asymmetric cover against price movements

Are optional (to exercise)
With Futures, you are committed

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Call option profit and loss payoff profiles

The value of the option to the buyer or holder
(long call party) is:
V = max(S - X, 0) - P
The value of the option to the writer (short call
party) is:
V = P - max(S - X, 0)

Options limit the effects of adverse price

movements without reducing profits from
favourable price movements
Options involve the payment of a premium by the
buyer to the seller (writer)

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Covered and naked options

Unlike the case with futures, the risk of loss

for a buyer of an option contract is limited
to the premium
However, sellers (writers) of options have
potentially unlimited risk and may be
subject to margin requirements unless they
write a covered option

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Covered and naked options

The writer of a call option has written a
covered option if the writer either:

owns sufficient of the underlying asset to satisfy

the option contract if exercised; or
is also the holder of a call option on the same
asset, but with a lower exercise price

The writer of a put option has written a

covered option if the writer is also the
holder of a put option on the same asset,
but with a higher exercise price

I.e. the writer of an option holds the underlying

asset or provides a financial guarantee

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Option markets are categorised as:

Over the counter
Exchange-traded

These are recorded through a clearing house

Clearing house acts as counterparty to buyer
and seller, thus creating two options contracts
through the process of novation
The clearing house allows buyers and sellers
to close out (i.e. reverse) their contracts

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International options markets

An exchange in a particular country will usually specialise in
option contracts that are directly related to physical or
futures market products also traded in that particular
country
Trading on international exchanges varies
The largest exchanges, the Chicago Board of Trade
(CBOT) and Chicago Mercantile Exchange (CME), retain
open-outcry trading on the floor involving 4000 to 5000
people
International links between exchanges allow 24-hour
trading

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Intrinsic value

The market price of the underlying asset relative to the

exercise price
The greater the intrinsic value, the greater the premium, i.e.
positive relationship
Options with an intrinsic value
Positive are in the money and the buyer is able to
exercise contract at a profit
Negative are out of the money and the buyer will not
exercise
Zero are at the money

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2.

3.

Time value

The longer the time to expiry, the greater the

possibility that the option will be able to be
exercised for a profit (in the money); i.e.
positive relationship
If the spot price moves adversely, the loss is
limited to the premium

125.220 Semester 2, 2015

Price volatility

The greater the volatility of the spot price, the

greater the chance of exercising the option for a
profit, or a loss
The option will be exercised only if the price
moves favourably
The greater the spot price volatility, the greater
the option premium; i.e. positive relationship

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4.

Interest rates

Interest rates have opposite impacts on put and call options

Positive relationship between interest rates and the price
of a call
Benefit of present value of deferred payment if exercised
> lower present value of profit if exercised
Negative relationship between interest rates and the price
of a put
Opportunity cost of holding asset
Lower present value of the profit if exercised

An over-the-counter financial product allowing

parties to enter into a contractual agreement to
exchange cash flows

Intermediated swap

Direct swap

A party enters into a swap with a financial intermediary

Two parties enter into a swap with each other without
using a financial intermediary

Two main types of swap contracts

Interest rate swaps
Cross-currency swaps

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1.

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Interest rate swaps

The exchange of interest payments associated with a

notional principal amount
Notional principal amountthe underlying amount
specified in a contract that is used to calculate the value
of the contract
Vanilla swapa swap of a series of fixed interest rate
payments for floating interest rate payments
Basis swapa swap of a series of two different reference
rate interest payments
Swap ratethe fixed interest rate specified in a swap
contract

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2.

Cross-currency swaps

Two parties, such as a bank and a company, exchange

debt denominated in different currencies
Interest payments are exchanged
Principals exchanged at beginning of agreement and
then re-exchanged at conclusion of agreement, usually
at the same exchange rate
Example:

If the swap is an AUD-USD contract based on USD1 million

and an exchange rate set at AUD/USD0.9245, at the start of
the contract one party would exchange USD1 million for
AUD1081 665.76
At each future interest payment date, interest payments
would be calculated using the same exchange rate; i.e.
AUD/USD0.9245
Finally, at the swap completion date, the original AUD and
USD principal amounts would be re-exchanged

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