Risk Management (BMS) (DP) Risk Hedging Instruments and Mechanism

87
86 AND
DEFINITION Advantages of Forwards:
4.1 DERIVATIVES (a) Customized in nature:
FORWARDS: In forward contract terms and
Monetary Fund or IMF defines conditions are decided depending upon requirements of
The International instrumentsthat are linked to a parties entering into the contract.
derivatives as "financial commodity and
instrument or indicator or (b) No need of exchange or clearing corporation: As
specific financial risk can be traded in
financial forwards are not exchange settled it is possible to enter
through which specific value of a
in their own rights. The into such contract without the need of any exchange or
financial markets
derives from the price of an underlying clearing corporations.
financial derivative
asset or index. Unlikedebt security, no
item, such as an
advanced to be repaid and no investment 4.2 FUTURES:
principal is
income accrues." FUTURES: Futures is an agreement between two people
between two people
Forwards: Forwardis an agreement or entities where settlement takes place on future date at
takes place on future date at a price whic is pre decided. It differs from forward in the
or entities where settlement
they are customized in
price which is pre decided.However way that ey are exchange traded and are standardized in
Hence credit risk
nature and are not exchangetraded. nature.
associated with them is high. Important Characteristics of Futures:

Important Characteristicsof Forwards: (a) Exchange traded: Futures are exchange traded, hence
counterparty risk: Forward are !not counterparty risk don't exist.
(a) Exposed to

exchange traded and are hence exposed to counterparty (b) Standardized in nature: They are standardized in
risk. nature where all terms related to contracts are decided
(b) Customized in nature: Contracts are designed by exchange.

depending upon needs of entities. Hence each contract (c) Cash or delivery based settlement: Final settlement
is unique in term of contract size, expiration date, asset can either be cash based or deliverybased.
type etc. Advantages of Futures:
(c) Delivery base settlement: Usually on expiry contractS
(a) Exchange traded: As futures are exchange traded
are settled by physical deliveryof underlying asset. counterparty risk does not exist.
 Risk Management (BMS) (DP)
RiskHedging Instruments and Mechanism
88 89
platform:As most stock exchan gee
trading it is possible for (h) Initial margin: The amount
(b) Electronic that must be deposited in
electronic tradingplatform the margin account at the time a
provide in futures contract. futures contract is
people to easily take positions first entered into is known as initial margin.
possible to take
risk: It is
to hedge
(c) Low cost means (i) Marking-to-market: In the future market, at the end of
futures by merely paying initial margin and
positions in each trading day, the margin account is adjusted to
risk.
means to hedge
hence it is cheaper reflect the investor's gain or loss depending upon the
Futures Terminology: future closing price. This is called marking-to-market.
which asset is traded in cash
(a) Spot price: Prices at Maintenance margin: It ensures that marginaccount
market. never become negative and is always somewhat less
asset is traded in
(b) Future prices: Prices at
which than initial margin. If the balance in the margin
market
futures account falls below the maintenance margin, the
cycle: It means period over which contract investor receives a margin call and is expected to top up
(c) Contract
expire on last Thursday of every the margin account to the initial margin level before
are traded. Futures
lastThursday a new
month. On next Fridayfollowing
trading commences on the next day.

contract is introduced for trading.

(d) Expiry date: It is last date on which contract win be .3 OPTIONS:

traded. OPTIONS: Options is an agreement which gives buyer

(e) Contract size: The amount of asset that has to be t but not obligationto buy or sell a specific quantity of
&Evered under one contract
lying asset on a future date at a pre determined
•ccs. Options are of two type call and put. Call option
Basis: Basis is definedas differencebetweenfuture
es buyer or holder right but not obligation to buy
and spot prices. In normal market conditions basis is
Yingasset on a future date at a pre determined
a}vayz psitive which means futures price exceeds
Put option gives right but not obligation to sell
marketprice.
mdcrlying asset on a future date at a pre determined
Cost of carry: Cost carry explains relatioÜ
between futures and prices.It measures storag
Eaportant Characteristic of Options:
pus interestthatis paidto financethe asset W
tiz incnmeeamed on BJ Exchange traded: I ike futures, options are also
exchange traded hence counterparty risk don't exist.
 Risk Hedging Instruments and
Again like futures, options
Mechanism 91
in nature:
(b) Standardized where all terms related (e) Option price: Option
nature price or option premium is
standardized in exchange. amount paid by option buyer to
by option seller to buy the
contract are decided option.
not obligations: Options gives
(c) Gives right but obligationto buy or sell (f) Expiration date: It is last date on
which options will be
holder right but not
traded.
future date.
quantity of asset on a (g) Strike price: It is price specifiedin option contract and
Advantages of options:
is also Imown as exercise price.
options are exchange tr
traded: As
(a) Exchange (h) American option: American option is one which can be
exist.
counterparty risk does not exercised on any day up to maturity.
As most stock exchan
(b) Electronic trading platform:
(i) European options: These options can be exercised only
it is possible
provide electronictrading platform on expiration day.
options contract.
people to easily take positions in U) In-the-money-option (ITM): These are options which
Options Terminology: lead to positive cash flow for holder if they are exercised
(a) Buyer of option: Buyer also known as holder is • immediately. Call option is ITM if spot is greater than
person who pays premiumto seller and buys right strike and put is ITMif strike is greater than spot.
not obligation to buy or sell given quantity of asset (k) Out-of-the-money-option (OTM): These are options
future date at a pre determined price. which lead to negative cash flow for holder if they are
(b) Seller of option: Seller also known as writer is exercised immediately. Put option is OTM if spot is
person who receivespremiumand hence is obliged greater than strike and call is OTMif strike is greater
buy or sell asset if buyer exercises the option. than spot.

(c) Call option: Call option gives buyer or holder right (l)/ At-the-money-option (ATM):These are options which
not obligationto buy underlyingasset on a future lead to zero cash flow for holder if they are exercised
at a pre determined prices. immediately. Both call and put will be ATMif spot is
(d) Put option: Put option gives right but not obligation equal to strike.
sell underlying asset on a future date at a (m)Intrinsic value of option: It is amount by which an
determined prices. option is ITM. If option is OTMthan intrinsic value is
zero.
 eblvt»n it caned as babdlty swap and u there •s
of interest income it IScalled swap
ot IRS:
4.4 SVAPS: It requtres tniual exchange of pnncipal (optional).urn
exchange of interest and re-exchangeof prtnctpal amount
• hiturt date according to (only if principal is exchanged at beginmng). A swmple
mterest rate swaps are popularly called Plam vanilla swaps
follows.
Se "tures waps are as To understand this let us assume that there are two
Hereif one party defauht firms A & B. Firm A has better credit rating as compared to
ternin•tioo of
the contract and clan
can trr•tntn.te firm B. Firm A requiresloan in fixed rate and B requires
other
loan in floatingrate. Both approach a bank to raise fund of
does not appear as Rs- Followingare rates given to firm A & B by
(b) Bo effect on balancesheet: bank.
it not a loan.
babil'ty on the
have higher Fixed rate (%) Floating rate
(e) Higher liquidity:
pate vvvaptrans— 8 MlBOR•3
and hence mart'.
Swapa are uned or habLlitiesin 10 MlBOR•6
which to on convert
or vice a From above it can be seen that firm A have absolute
a•æt/bAb11ttv Ltltoflied advantage in both fixed and floating rate. However fixed
Swaps can bc term and long Ern
rate for firm B is only 2% more than firm A whereas floating
Short term swaps have a matutity01 less than 3 rate is 3% more. Thereforefirm B have a comparative
medium term have a between to 5
advantage in fixed rate. Hence accordmg to theory of
long tettn have a maturitv 01more than %vears. 'comparauve advantage firm B should borrow tn fixed rate
VARIOUS STRUCTURAL MODELS OF SWAPS: and firm A should borrow in noaung rate,
interest Rate Swaps:InterestRate Swaps is Howeverfirm A requires loan in fixed rate and B requues
according to thetr
where two or more parl.tesagree to exchan* ban •n floaung rate. If they t»rrow
be
oblagauon or income over a period 01urne which is requirement total cost of borrovtng
in swap aveement If there is exchange Of
 Following dingrum shows the wociOngmechanjum
according to theory of compeicqtivc currency
of
iCthey borrow rate and firm
firm borrows in fixed ot Cinncipal
advantage i.e. of borrowing
rate then total cost
should borrowoin flouting
will bet Exchange of Interest
to • MIBOR +3 • MIBOR+
if firm B borrows fix and firm
Hence it can be seen that Re-exchanoo ot Principal
1% which can be Shared
floating they can benefit by
between them,
swap agreement where It involved three baaic Otepa:
Thus both firms can enter into a
then exchange their (a) Initial exchange of principal
firm B borrows fix and firm A floating
principal amount and interest obligation so that they can (b) Exchange of interest installments
fulfill each others requirement.It can be seen that such (c) Re-exchange of principal
agreement is beneficial to both of them. Equity Swaps:
Valuation of IRS: Equity swaps is defined as an agreement to exchange
Value of IRS is gives as: dividends and capital gains on a portfolio, based on a stock
V =Fb-Ff index against periodic interest payments. Suppose Ms.
Where V = Value of the swap
Sachika, a fund manager manages a portfolio of stocks
invested in an index fund. Underlyingindex is nifty. Nowif
Fb = Value of fixedcoupon bond.
Ms. Sachika becomes bearish about nifty and wants to
Ff = Value of floating rate note. kedge her position, she can enter into an equity swap
Currency Swaps: egreement where she pays returns on nifty portfolioand
It is definedas an agreementbetween two parties to eceives fixed payment in exchange. But for this it is
exchange interest payments on loan in one currency to an ecessary to find a counterparty that is bullish about nifty
equivalent loan in another currency. In currency swaps }and is ready to pay fixed rate for nifty returns.
principal amount may or may not be exchanged. (In most Equity swaps can be easily understood by referring
currency swaps principal amount is exchanged and is diagram given below.
re-exchanged at expiry of agreement)
 97
are defined as
on
be Can Swaption or Put
SwaptZn-
(1) Call S•aptioa: A can
swaptim gives its holder ri$%tto
enter into a swap
as a Exed rate payer. On the
other
hand writer is floating rate
payer- A firm will buy Call
swaptionsif it is of the view that interest rate
Till
Cenodity increase and hence is
willing to pay fix rate and receive
Thereby one party pays a floating rate. But firm is also worried that
&fined as an interest rates
fred prie quantitycfcommodity and second
a definite
might starts falling after a certain
period and hence
of commodity over buys a call swaption so that
pz•ty pays maket rate for sane quantity depending upon movement

swap perid
of interest rate it may enter into swap deal or let option
expire.
Such commodity swap is very useful for producers and
who sells sugar. (2) Put Swaptions:
dealers of commodities. Consider a dealer A put swaption gives its holder right to
enter into a swap
Dealer is not sure about prices of sugar in next few as a floating rate payer. On the other
about its volatility. Under such hand writer is fixed rate payer. Buyer of put swaption
and is worried is

circumstances dealer ran enter into a commodity swap of the view that interest in future will decrease and
ageement. Dealer will receive a fixed amount each year hence is willingto pay floatingrate and receive fixed
will have to pay market prices of sugar. In this way dealer is rate. But simultaneouslyis worriedthat interest rate
assured that he will receive a fvcedamount each year. might starts rising after a certain period.
Commodity swaps can be easilyunderstood
Advantages of Swaps:
by refer-ring
diagram given below. (1) Currency swaps unlike back to back loan does not
Marketprice of appear on liability side of balance sheet.
commodity
(2) Through Interest Rate Swaps it is possible to reduce
Produceror interest liabilities of parties entering into swap
dealerof Fix rate
commodity payer
agreement.
Fix Rate
(3) International diversificationof portfolio is possible
through equity swaps.
 99
to receive a
cotnmod)ty saps it is target company shares will rise as the
(4) Through commodity producers or acquirer's share
Hence tend to fan.
amount for commodxty- against commodity risk.
themselves Index Arbitrage: The arbitrageur will buy all of the
dealers can hedF
Limitatiozs of "apse stocks of the underlying index and sell the futures for the
Many a times it becomes index. In the process, the investor will borrow money to buy
(1) Lack of counterparty:
counterparty for swap deals the stocks, pay interest on the loan and earn dividends on
dimcult to find a suitabk
swap dealer need to be the stocks. As such, the expected profit is equal to:
To find
a part of profit from
approached who usuallycharges Cost of stocks plus dividends on stocks minus interest
deal as fees. costs minus futures value.
markets for swaps are not
(2) OTC traded: Secondary Carry Trade: This can be done in the foreign currency
are traded over the
developed fully and most swaps (forex) markets or may also be performed in the bond
counter. markets. In the forex markets, the investor would buy a
a-aded. there are high high-interest currency and finance that with the selling of
(3) Default risk: As swaps are OTC
chances of counterparty default. low-interest rate currencies.
International Arbitrage: When foreign-based companies
4.5 ARBITRAGE TECHNIQUES: issue stock in their country, these are referred to as
ordinary shares (ORDs).In order to allow investors in other
Arbitrage is defined as the simultaneous buying and
markets, such as in the United States. to have ownership in
selling of securities, currency. or commodities in different
of one of these companies, the company will issue American
markets or in derivative forms in order to take
Depository Receipts (ADRs)or Global Depository Receipts
differing prices for the same asset.
(GDRs).Here the arbitrageur buy the ORDs shares and
Risk Arbitrage: Here the arbitrageur will buy shares Of
short-sell the ADRs or vice versa, depending on their
the target company and sell shares of the acquiring relative valuations.
company in a ratio equal to that of the projected
transaction. In the event of a cash-for-stock deal, the Convertible Arbitrage: Prom time to time, corporations
arbitrageur will buy shares of the target company and will issue debt that is convertibleinto shares of the issuing
borrow money to finance the transaction. As a result, when company. By doing so, the companywill pay an interest
a new (merger and acquisition) deal is announced, the rate that is lower than that Whichwould be paid on non-
convertible or "straight" debt. Convertibledebt is a hybrid
 Instruments ond Mechanism
Hedging

converted into equity sharea of the apecific sectora or single atoclc that
aecuriw may be have higher risk
asbitrageseeks to take advantage of and rewardo.
company, Conveci.ible are oasociated with the
prioiog ireegoiarities Converaely, a portfolio holding ahort-term Treasury's
convertiblebood,
embeddea option in the pcenentNIow rinlclevela combined with limited returns,
For inve»tora, nanenning the growing riNk•return
OFF:
4.6 RETURN TRADE tradeoiï of all ponitiona can provide insight on whether
principle potential povt(olio annutned enovtgli rislc to achieve long-
The trad«oftig the
ciNlc.Low levets of
roturn with an Increaoe in term veturn or ciNlclevela ave too high
uncertainty or are angoeintedsvith Iow potentIAl witli the exiNtingcombinntion of holdinga.

veturng. Icveloo/ unccrtAinty ov are

nanocioted wit)• potential Aeeotxling to the .7 MARKowrrz RISK RETURN MODEL:
tnonc,y higher pot'lfolio tbcoty (MIT) theoty on bow viNlc•
the inventor in to accept the
profitti only i!'VCNtOVN contattuet pot•tColi0Nto optitnize 08'
Ionncn, expected Oti Icvel Of
For invenlotN, Ilic ti vulcolÏ one Of part oc
('ognponcnfn 11 inventtncnt (lecit•ion IO thcot•y, it\N l'ONNibtc to

woll io tbc 01 pot Iloli0N a whoie, At (lootict•'i of optiniAl (oli0N the

conni(lcratlon Of 1)0NNiblcexpec(ed (ov Riven levet ot•
01 nn invc«tgncnt IPI' Ataoumplion invcatotm
potat•olio(o
thcy prcfct• (CN*t•iNlqy one Cot'
clo(crtnine talcinp, neti01i t•ennc OC note At
givcn Icvel Of Thin implica invetatot'Will
the por(tolio levcl, tbc include
00 viale onuv he o" cxpceting nxotx:

or o Iowee tljnn (Icaitcd t•etum•. wruxl,

expected
'1*110 Of 111cpor(Colio calcula(ed
The nlno cxinin (11cportfolio lovel,
NUtnof the individual agocta' It• povttOlio
For example, n porl(olio of All cquitieO expec(ed
prc«cntg both liighcr rinl( angl polentinl (or highet nonincd fout• equalW•wcighted
turno of 4, 6, IO and 14%. the portfolio't•
expce(cd
retut•ng. Witl)inon povAlòlio, and reward
be inerennecl by ine.lx•ntging oulcl be:
concentration• in
 Heagmg Instruments and
102 Mechanism

+ (10% * 25%) + (14% x 25%)

25%) It is often viewedas an alternative
(4% x 25%) + (6% * to the capital asset
- 8.5% pricing model (CAPM).Also the APT has more flexible
function of
a complicated th assumption
The portfolio's risk is correlations of each pair of
requirements. Whereas the CAPM formula
the requires the market's expected return, APTuses the risky
variances of each asset and four-asset portfolio
risk of a asset'S expected return and the risk premium of a number
assets. To calculate the variances and
four assets' of macroeconomic factors. Arbitrageurs use the Apr model
investor needs each of the correlations,
asset the total to profit by taking advantage of mispriced
correlation values. Due to the lower
securities, which
deviation, is than what have prices that differ from the theoretical price predicted
portfolio risk, or standard
sum. b! the model. By shorting an overpriced security, while
would be calculated by a weighted
four steps involvedin simultaneously going long in the portfolio the APT
According to the theory, there are
of a portfolio: calculationswere based on, the arbitrageur is in a position
the construction
various assets in terms to make a theoretically risk-free profit.
(1) Security valuation: Describing
APTstates that the expected return on a stock or other
of expected returns and risks.
asset
urity must adhere to the followingrelationship:
(2) Asset allocation: Distributing various classes
Expected return = r(f) + b(l) x rp(l) + b(2) x rp(2) + ... +
within the portfolio.
b ) x rp(n)
(3) Portfolio optimization: Mergingrisk and return in the
Where,
portfolio.
r(f)= the risk-free interest rate
(4) Performance measurement: Dividing each assets
performance into market-relatedand industry-related b = the sensitivityof the asset to the particular factor
classifications. rp = the risk premium associated with the particular
tor
4.8 ARBITRAGE THEORY: The number of factors will range depending on the
Arbitrage pricing theory is an asset pricing model based ysis. There can be a few or dozens; it depends on which
on the idea that an asset's returns can be determined using f tors an analyst chooses for the analysis. In addition, the
the relationship betweenthat asset and many common risk ct factors do not have to be the same for all analysis. As
factors. example calculation, assume a stock is being analyzed.
e followingfour factors have been identified, along with
 Risk rteøgmg Instruments and Mechanism
IOS
factor and the risk
to each transactiOns, measure ongoing performance, maintain
the stocks sensiuviqy adequate business records and to promote operational
factor:
associated with each rp 4%
growth:b 0.6,
product, productivity. Internal auditors review the design of the
Gross domestic
rp 2% internal controls and informally propose improvements,
Inflation rate: b •s0.8, and document any material irregularitiesto enable further
rp 5%
Gold prices: b • -0.7, b 1.3, rp investigationby management if it is warranted under the
index return: 9%
Standard and Poor's500 circumstances.
The risk-free rate is 3%. System audit is an examinationof the management
formula,the expected return i:
Using the above API' controls within an Information Technology (IT)
calculated as: infrastructure.
x 4%) + (0.8 x 2%)
Expected return = 3% + (0.6 Role of System Audit in Risk Mitigation:
0.7 5%) + (1.3 x 9%) 15.2% The primary functions •ofan IT audit are to estimate the
systems that are in place to watch an organization's
4.9 SYSTEM AUDIT SIGNIFICANCE IN RISK
information.
MITIGATION:
Information technologyaudits are used to calculate the
Auditing is a means of assessingthe effectiveness ofa organization's ability to protect its information assets
company's internal controls. Maintaining an effective and to properly distribute information to authorized
system of internal controls is vital for achieving a parties.
company's business objectives,obtaining reliable financial IT audit ensure that there is no leakage of information
reporting on its operations, preventing fraud and misuse Q' and that informationis availableonly with authorized
its assets, and minimizingits cost of capital. Both internal personnel.
and independentauditorscontributeto a company's audi:
System audit moderates risk by calculating the
system in different but important ways.
organization's internal control design and effectiveness.
Having an effectiveaudit system is important 'for
company because it enables it to follow and attain it:
System audit is important to ensure that information
various corporate objectives.Business processes need provided by the system is always accurate, reliable, and
various forms of internal control to facilitate supervision timely thereby reducing IT risk significantly.
and monitoring, prevent and detect suspicious
 Risk Management (BMS)
Risk Hedging Instruments and Mechanism
124
selling futures on 1 Nov trading (e) The risk-return tradeoff is the principle that potential
to hedge risk by return rises with an increase in risk.
of Novexpiry.
are
Rs. 130. Futures that price on [Ans.: (a) True; (b) False; (c) False; (d) True; (e) Truel
there is 60 % chances (3) Define Forwards.
Additionally
Rs. 120, 35% chances that prices willbe (4) Define Futures, Options and Swaps.
expiry will be will
price be Rs. 135.
chances that (5) Discuss Swaps.
Rss 130 and 5%
Mr. Chouhan. (6) Arbitrage Techniques.
Calculate profit/loss for
(7) Briefly discuss Risk Return Trade off.
(8) Write a note on Markowitz Risk Return Model.
4.12 QUESTIONS: (9) Discuss ArbitrageTheory.
(1) Fill in the blanks: two people (10) Discuss System Audit Significance in Risk Mitigation.
is an agreementbetween (11) Explain the various structural models of Swap. (April 17)
takes place on future date ata
entities where settlement (12) Define Arbitrage. Explain the types of arbitrage techniques.
price which is pre decided. (April 17)
(b) is an agreementbetween two people
on future dateat
entities where settlementtakes place
price which is pre decided.
(c) Options are of two type call and
(d) is defined as an agreement where two
parties agree to exchange cash flow on a future date
according to a predeterminedarrangement.
(e) A call gives its holder right to enter intoa
swap as a fixed rate payer.
[Ans.: (a) Forward; (b) Futures; (c) put; (d) Swap
(e) SwaptionJ
(2) True or False:
(a) A put swaption gives its holder right to enter into a swag
as a floating rate payer.
(b) Lack of counterpartyis nota limitationsof swaps.
(c) In risk arbitragethe arbitrageurwill buy all of the stockf
of the underlying index and sell the futures for the index
(d) When foreign-based companies issue stock in the
country, these are referred to as ordinary shares (ORDS)•