Financial Derivatives and Risk Management

What is Risk?
Risk is deviation between actual and expectations.

Ex: When a bank lends to a customer, it is exposed to credit risk or default risk, as there is a
chance that the customer does not pay equated monthly instalments (EMIs) on time.

If the customer prepays the loan also,

• The bank foregoes interest income on loan

• The bank is exposed to reinvestment risk, as it has not planned where to reinvest the
money received beforehand from the customer.

To make the concept simpler, take the following example about the performance of two
students. (This is only for example and not to use for giving explanation in case of finance
related risks)

Subject Student A Dev Square Student B Dev Squared Dev

d Dev
1 60 0 0 90 30 900
2 60 0 0 30 -30 900
3 60 0 0 60 0 0
4 60 0 0 30 -30 900
5 60 0 0 90 30 900
Averag 60 60 3600
e
SD 3600/4= 900
(Var)
0 SD= 30

Despite average mark of both the students is same, Student A is said to have performed better
as there is consistency in his performance. In other words, deviation is zero. In case of second
student, squared value of deviation provides same result (900), whether it is -30 or +30. It
means that deviation whether it is negative or positive indicates risk. The most popular way
of measuring risk is standard deviation.

Risk Vs. Uncertainty

Risk: A situation to which probability of occurrence can be assigned. Ex: change in currency
value, loan default or repayment etc.

Uncertainty: A situation to which probability of occurrence cannot be assigned. Ex: COVID-

19 and Sub Prime Crisis 2008 etc.

Characteristics of Black Swan Events like COVID-19:

1
 • Unpredictability (We cannot assign any probability)
• Beyond normally expected events (rare events)
• Severe consequences
• Severe impact (Social, Political, Economical or Combination of All)

Sources of Risk (Types of Risks)

i. Policy risk or regulatory risk: Ex: GST implementation, demonetisation, two types
of income tax slabs etc.

ii. Political risk: Instable political parties ruing the country

iii. Social risk: Exposure of people to various crises like hunger etc.

iv. Operational risk: Risk that arises due to system mistakes, human interference,
technical errors etc.

v. Concentration risk: Risk of concentrating in a single portfolio

vi. Event risk: Risk of unexpected events or God’s events

vii. Financial risk: The following is the list of few financial risks:

• Inflation risk: When the prices go up, purchasing power comes down
• Interest rate risk: Exposure of borrowers and lenders to rate changes
• Foreign exchange risk: This includes three types of exposures (Transaction
exposure, translation exposure and economic exposure)
a. Transaction exposure: It arises when transactions actually take place. Ex:
Borrowing before exchange rate change and repaying after exchange rate change,
payment for imported goods etc.

Value in Befor Value in Rs. Value (Domestic Impact

foreign e rupee (Domestic (Impact) currency
currenc terms currency depreciates
y ($) appreciates or foreign
or foreign currency
currency appreciates)
depreciates)
Asset 10,000 73 7,30,000 72 7,20,000 74 7,40,000
(Negative (Positive)
)
Liabilit 10,000 73 7,30,000 72 7,20,000 74 7,40,000
y (Positive) (Negative)
Income 1,000 73 73,000 72 72,000 74 74,000
(Negative (Positive)
)
Expense 1,000 73 73,000 72 72,000 74 74,000
(Positive) (Negative)

2
 If asset is denominated in the currency which is appreciating, value of the asset also
increases leading to positive impact and vice versa
If liability is denominated in the currency which is appreciating, the value of liability
also increases leading to negative impact and vice versa
Ex: Last year, you have taken loan when Rs./$ was Rs.73, inflow through loan was
Rs, 7,30,000. If exchange rate this year when you have to repay loan is Rs.72, your
cash outflow in rupee is Rs, 7,20,000 resulting in less outflow than inflow, hence
positive impact.
If exchange rate this year when you have to repay loan is Rs.74, your cash outflow in
rupee is Rs, 7,40,000 resulting in more outflow than inflow, hence negative impact.
You can apply similar logic for assets, income and expenses to understand the impact.
b. Translation Exposure: Also known as accounting exposure, as it arises, when
you are maintaining your books of accounts (such as income statement, balance sheet,
cash flow statements etc) in foreign currency and translating those figures into
domestic currency to report to shareholders. Unlike in transaction exposure, here gain
or loss is notional. Impact on assets, liability, income and expenditure is same as
explained above.
c. Economic exposure: The exposure that can directly affect the value of the
firm. It can have impact on operating cash flows.

Value Befor Value Rs. Inflow/Outflo (Domestic Inflow/Outflo

in e in rupee (Domestic w Currency w
foreign terms Currency (Impact) Depreciate (Impact)
currenc Appreciate s and
y ($) s and foreign
foreign currency
currency appreciates
depreciates )
)
Export 10,000 73 7,30,00 72 7,20,000 74 7,40,000
s 0 (Negative) (Positive)
Import 10,000 73 7,30,00 72 7,20,000 74 7,40,000
s 0 (Positive) (Negative)

• Depreciation of domestic currency/appreciation of foreign currency has

positive impact on exports/negative impact on imports and vice versa

• Appreciation of domestic currency/depreciation of foreign currency has

positive impact on imports/negative impact on exports and vice versa

• Market risk: Change in asset values due to change in market prices

• Liquidity risk: If not able to do the following, exposed to liquidity risk
• Ability to find counterparty
• Execute the transaction at reasonable price
• Execute the transaction immediately
• Reinvestment risk: Risk that arises due to redeployment of funds at lower rate

3
 • Credit risk: Inability to collect money from the clients
Downgrade risk: The possibility of downgrading the rating of the bond
Default risk: The possibility that the customer defaults the payment

Financial Risk: Exposure of firm’s earnings (revenues), cash flows, and values to external
factors like interest rates, inflation rate, exchange rate etc.
Risk Management Techniques

Risk Avoidance: Ex: Not undertaking any business which is not financially feasible.
Risk Retention: Identify acceptable risk and retain it, if cost of managing is more.
Risk Diversification: Investment in less correlated assets
Ex: Investment in Nifty 50 stocks rather than Bank Nifty stocks
Risk Separation (Spreading): Ex: Maintaining inventory at multiple locations
Loss Control: Ex: Keeping a security at Jewellery shop
Risk Transfer: Transfer of risk to those who are willing to accept without necessarily
transferring the asset. Ex: Insurance and hedging
Hedging: Protecting against unfavourable or adverse price movements, by fixing the price to
be paid or received in future
Ex: Infosys exports $1000 software to a company in the US and it receives payment in $ after
a month. It is exposed to the risk of changes in $ price. Hence, Infosys can fix the price today
itself by entering a forward contract.
When you approach a bank for entering forward contract, it has given the following bid-ask
quotes, as bank is a market maker. The authorised dealer who gives bid-ask quotes is called
market maker.
Bid (Purchase Price to Ask (Sale Price to the Bid Ask Spread
the bank and sale price bank and purchase
to customer ) price to the customer)
Spot 73.23 73.26 0.03
1- month 73.27 73.29 0.02
forward
2-month 73.30 73.32
forward
3-month 73.35 73.38
forward

Bid: Purchase price from bank’s point of view (sale price for client)
Ask: Sale price from bank’s point of view (purchase price for client)

Since you receive dollars from your customer after a month and sell those dollars to bank,
applicable price is 1-month forward bid price = 73.27.
Price fixed in forward contract is Rs. 73.27
After a month, your cash inflows = Rs.73.270
If $ = 72 after a month, you are benefitted, instead of 72,000, your inflow will be fixed at
72,270

4
If $= 74 after a month, you are losing, instead of 74,000, your inflow will be fixed at 74,270
This is called Hedging.
Hedging protects from adverse price movements, but also limits upside potential.