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    The Only Certainty Is That There Will Be "Uncertainty": Risk Management

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    vneves
    Risk management has become increasingly important due to growing financial volatility. Derivatives are financial instruments whose value is derived from underlying assets like currencies, commodities, stocks, etc. There are four main types of derivatives - forwards, futures, options, and swaps. Forwards are bilateral contracts to buy/sell an asset at a future date, but have counterparty risk. Futures are standardized, exchange-traded versions of forwards that reduce counterparty risk. Options give the buyer the right, but not obligation, to buy/sell the underlying asset at a set price.

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    The Only Certainty Is That There Will Be "Uncertainty": Risk Management

    Uploaded by

    vneves
    51 views24 pages
    Risk management has become increasingly important due to growing financial volatility. Derivatives are financial instruments whose value is derived from underlying assets like currencies, commodities, stocks, etc. There are four main types of derivatives - forwards, futures, options, and swaps. Forwards are bilateral contracts to buy/sell an asset at a future date, but have counterparty risk. Futures are standardized, exchange-traded versions of forwards that reduce counterparty risk. Options give the buyer the right, but not obligation, to buy/sell the underlying asset at a set price.

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    Call & Put

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    Risk management has become increasingly important due to growing financial volatility. Derivatives are financial instruments whose value is derived from underlying assets like currencies, commodities, stocks, etc. There are four main types of derivatives - forwards, futures, options, and swaps. Forwards are bilateral contracts to buy/sell an asset at a future date, but have counterparty risk. Futures are standardized, exchange-traded versions of forwards that reduce counterparty risk. Options give the buyer the right, but not obligation, to buy/sell the underlying asset at a set price.

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    Download as ppt, pdf, or txt
    51 views24 pages

    The Only Certainty Is That There Will Be "Uncertainty": Risk Management

    Uploaded by

    vneves
    Risk management has become increasingly important due to growing financial volatility. Derivatives are financial instruments whose value is derived from underlying assets like currencies, commodities, stocks, etc. There are four main types of derivatives - forwards, futures, options, and swaps. Forwards are bilateral contracts to buy/sell an asset at a future date, but have counterparty risk. Futures are standardized, exchange-traded versions of forwards that reduce counterparty risk. Options give the buyer the right, but not obligation, to buy/sell the underlying asset at a set price.

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    Risk Management

    The only certainty is that there will


    be “uncertainty”

    • Increasing Financial volatility

    • Leading to explosion of new financial products


    Derivatives
    ….these are instruments whose value is based, or derived from
    the prices of currencies, interest rates, shares, commodities, etc.

    Broadly four types of derivatives are traded:

    - Forwards
    - Futures
    - Options, and
    - Swaps
    A forward contract is an agreement to buy or sell an asset on a
    specified date for a specified price.

    Salient features of forward contract:


    • Bilateral contracts and hence are 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
    • On the expiration date, the contract has to be settled by delivery
    of the asset
    • If the party wishes to reverse the contract, it has to compulsorily
    go to the same counter party, which results in high prices being
    charged
    Forward contracts are very useful in hedging and speculation.

    Eg: The classic hedging application would be that of an exporter or


    an importer
     
    If a speculator has information or analysis, which forecasts an upturn
    in a price, then he can go long on the forward market instead of the
    cash market - wait for the price to rise, and then take a reversing
    transaction to book profits.
    Forward markets world wide are afflicted by several problems:
            Lack of centralization in trading
            Illiquidity and
            Counterparty risk

    • Future markets were designed to solve the problems that exist in


    forward markets
    FUTURES
     
    A future contract is an agreement between two parties to buy or
    sell at a certain time in the future at a certain price. But unlike
    forward contracts, the future contracts are standardized and
    exchange traded.

    The standardized items in a future contract are:


    • Quantity of the underlying
    • Quality of the underlying
    • The date and month of delivery
    • The units of price quotation and minimum price change.
    • Location of settlement
    PRICING FUTURES:
     
    Cost and carry model of Futures pricing:
    Fair price = spot price + cost of carry – Inflows
    FPtT = CPt + CPt * (RtT – DtT) * (T-t)/365
    Where:
    FPtT = Fair Price of the asset at the time t for time T
    CPt = Cash price of the asset
    RtT = Interest rate at the time t for the period upto T
    DtT - Inflows in terms of dividend or interest between t and T.
    Cost of carry = Finanacing cost, Storage cost and insurance cost
     
    If future price > Fair price; buy in the cash market and
    simultaneously sell in the futures market
    If futures price < Fair prce; sell in the cash market and
    simultaneously buy in the futures market
     
    This arbitrage between cash and future markets will remain till
    Assumptions:

    •No seasonal demand and supply in the underlying asset.


    •Storability of the underlying asset is not a problem.
    •The underlying asset can be sold short
    •No transaction cost; no taxes
    OPTIONS:
     
    An agreement between two parties in which one grants to the
    other the right to buy (“call” option) or sell (“put” option) an
    asset under specified conditions (price, time) and assumes to sell
    or buy it.
    The buyer of the option has the right but not the obligation to
    buy an agreed quantity of a particular commodity or financial
    instrument from the seller of the option at a certain time for a
    certain price. The seller or writer is obligated to sell the
    commodity or financial instrument should the buyer so decide
    OPTIONS:
     
    An option gives the holder of the option the right to do
    something. The holder does not have to exercise this right. In
    contrast, in a forward and futures contract, the two parties have
    committed themselves to doing something. This could br risky
    for contingent exposures.

    Whereas it costs nothing, except margin requirements, to enter


    into a future contract, the purchase of an option requires an up
    front payment.
     
    The buyer pays a fee called as a premium for his right.
    Features:

    Buyer of option:
    • right but not obligation
    • pays fees
    • potential unlimited profit

    Writer or Seller of Option:


    • obligation to fulfill contract
    • earns fees
    • potential unlimited loss
    CALL OPTION:
     
    The buyer of a call option wants the price of the underlying
    instrument to rise in the future; the seller either expects that it will
    not, or is willing to give up some of the upside (profit) from a
    price rise in return for premium paid immediately and retaining the
    opportunity to make a gain up to the strike price.
     
    Call option are the most profitable for the buyer when the
    underlying instrument is moving up, making the price of the
    underlying instrument closer to the strike price. When the price of
    the underlying instrument surpasses the strike price, the option is
    said to be “in the money”.
     
    CALL OPTION:
     
    A European style option allows the holder to exercise the option
    to buy only on the delivery date. An American option allows
    exercise at anytime during the life of the option.
     
    Example

    • Importer XYZ required to pay $10 mln on 30th Sept and


    wishes to limit outflow to Rs. 45.50

    • XYX buys a European style call option on USD maturing


    30th Sept at a strike price of Rs. 45.25 per US$ and at a
    premium of say 25 paise per dollar

    • If on expiry, the spot Re/$ rate is Rs. 46.50 per $, the


    importer will exercise the call option and take delivery of $
    10 mln at Rs. 45.25 per $. XYZ total cost will be Rs. 45.50
    per $

    • If on expiry, the spot Re/$ is say Rs. 44.50 per $, the


    importer will NOT exercise call option and buy the required
    dollars in the spot market. XYZ total cost is Rs. 44.75 per $
    PUT OPTION:
     
    A put option is a financial contract between two parties, the
    buyer and the seller of the option. The put allows the buyer the
    right but not the obligation to sell a commodity or financial
    instrument to the seller of the option at a certain time for a certain
    price (the strike price). The seller has the obligation to purchase
    at that strike price, if the buyer does choose to exercise the option.
     
    Note that the seller (the writer) of the option is agreeing to buy the
    underlying instrument if the buyer of the option so decides! In
    exchange for having this option, the buyer pays the seller a fee
    (the premium).
     
    PUT OPTION:
     
    The most widely-known put option is for stock in a particular
    company. In general, the buyer of a put option expects the price of
    stock to fall significantly, but does not want to sell the stock short
    because that could result in large losses if the stock does go up
    anyway. (With a put option, the loss is limited to the purchase
    price of the option.) The seller of the put option generally feels
    that the stock in question is reasonably priced, and should the
    price fall, the seller may be willing to become the owner of the
    stock at a lower price, considering it to be a bargain. On the other
    hand, the seller of the put may be merely gambling.
     
    Call / Put prices move inversely; are at parity when strike
    price = forward rate

    Strike Call Put


    44.10 74 19
    44.30 61 25
    44.50 49 33
    44.64 40 40
    44.80 34 48
    45.00 27 60
    45.20 21 74
      EUROPEAN OPTIONS AMERICAN OPTIONS
    BUYING BUYING

    PARAMETRE CALL PUT CALL PUT

    Spot Price (S)

    Strike Price (Xt)

    Time To Expiration (B)    

    Volatility ()
    a)      Spot prices: In case of a call option the payoff for the
    buyer is the maximum. Therefore, more the spot price more is the
    payoff and it is favourable for the buyer. Incase of a put option,
    more the spot price more are the chances of going into a loss.
     
    b)      Strike price: A higher strike price would reduce the profits
    for the holder of the call option
     
    c)      Times to expiration: More the time to expiration more
    favourable is the option. This can only exist in case of American
    option as in case of European Options and Options Contract
    matures only on the date of Maturity.
     
    d) Volatility: More the volatility, higher is the probability
    of the option generating higher returns to the buyer. The
    downside in both the cases of call and put is fixed but the
    gains can be unlimited. If the price falls heavily in case of a
    call buyer then the maximum that he loses is the premium
    paid and nothing more than that. More so he/ she can buy
    the same shares form the spot market at a lower price.
    Similar is the case of the put option buyer. The table show
    all effects on the buyer side of the contract
    In- the- money options (ITM) - An in-the-money option is an
    option that would lead to positive cash flow to the holder if it
    were exercised immediately. A Call option is said to be in-the-
    money when the current price stands at a level higher than the
    strike price. If the Spot price is much higher than the strike price,
    a Call is said to be deep in-the-money option. In the case of a Put,
    the put is in-the-money if the Spot price is below the strike price.
     
    At-the-money-option (ATM) - An at-the money option is an
    option that would lead to zero cash flow if it were exercised
    immediately. An option on the index is said to be "at-the-money"
    when the current price equals the strike price.
     
     
    Out-of-the-money-option (OTM) - An out-of- the-money Option
    is an option that would lead to negative cash flow if it were
    exercised immediately. A Call option is out-of-the-money when
    the current price stands at a level which is less than the strike
    price. If the current price is much lower than the strike price the
    call is said to be deep out-of-the money. In case of a Put, the Put
    is said to be out-of-money if current price is above the strike
    price.

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