Chapter 1

Introduction
Event Risk
 An unforeseen event can affect revenue and costs

 Increased fuel prices in 1973 in the USA caused American

automakers to suffer as they concentrated on building larger cars

 Foresight and appropriate strategy can help manage these risks

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Price Risk
 Arises when future cash flows are affected by changing prices of
inputs and outputs:

 Changes in price of commodities

 Changes in price of financial instruments

 Changes in price of money or interest rates

 Changes in price of currency or exchange rate changes

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Credit Risk
 Arises when customers’ credit rating falls

 When this occurs, the probability of default and bankruptcy

increase

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Risk Management
 Risk is unavoidable
 Operating and business, and event risk, can be management only
by formulating appropriate strategies based on anticipation
 Price risk, which occurs on a regular basis, can be managed using
derivative securities
 Credit risk can be managed through derivative securities

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Hedging
 Hedging is undertaken to reduce the risk of unknown future
prices

 Hedging is done using derivative securities

 Derivatives used are:

 Forward contracts
 Futures contracts
 Options contracts
 Swap contracts

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Forward Contracts
 Provide the holder of contracts with the right to buy or sell the
underlying asset at a future time at a price that is agreed upon at
the time of entering into the contract
 Both parties obligated to fulfill the contract
 Short-term, non-negotiable
 Typically over-the-counter

© 2011 Dorling Kindersley (India) Pvt. Ltd.

Futures Contracts
 Provide the holder of the contract with the right to buy or sell the
underlying asset at a future time at a price agreed upon at the time
of entering into the contract

 Both parties obligated to fulfill the contract

 Can be short- or long-term
 Negotiable
 Traded on futures exchanges

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Upside and Downside Risk
 When prices move in favour of a company, increased cash flow
will be produced and the company will face upside risk

 When prices move against a company, decreased cash flow will

result and the company will face downside risk

 When hedging, attention is placed on downside risk

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Options Contracts
 An option buyer has the right to either buy or sell the underlying
asset at a fixed price, at a future time
 Option buyers have no obligation to fulfill contracts, whereas the
writers have to fulfill the obligations if called upon to do so
 Options provide protection against downside risk, while
preserving upside potential; under forwards and futures, upside
potential is foregone
 Options can be either over-the-counter or traded in exchanges

© 2011 Dorling Kindersley (India) Pvt. Ltd.

Commodity Price Risk
 Commodity price risk arises when future prices of inputs and
outputs are uncertain

 Major determinants of price risk are:

 Volatility of movement of prices
 Liquidity of the market

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Interest Rate Risk
 Interest rate risk arises when future interest rates are not known

 Investors in fixed-income securities face interest rate risk—the

value of fixed-income securities are directly related to interest rate
movements

 Borrowers and lenders face interest rate risk, as interest rate on

loans depend on interest rates in the market

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Deregulation and Central Bank
Intervention
 Until the 1970s, interest rates were regulated with ceilings on
interest rates on deposits and loans

 With deregulation, banks can offer competitive rates

 The Central Bank can use interest rates as monetary tools to

determine money supply in the economy

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Floating-rate Loans
 Floating-rate loans are loans where interest rates are not fixed for
the whole term of the loan, and are set at periodic intervals during
the loan period based on basic interest rates in the economy

 Example: 6-month MIBOR + 200 points

 Interest rates on loans will be reset every 6 months.
 Interest rates will be 2% above the 6-month MIBOR at that
time

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Floating Rate Loan: Example (1)
Date loan taken January 1, 2011
Loan amount INR 1 million
Interest reset Every 6 months
Loan maturity 2 years
Base rate 6-month MIBOR
Premium 100 basis points (1%)
Actual MIBOR Loan Rate
January 1, 2011 8% 9%
July 1, 2011 8.6% 9.6%
January 1, 2012 9% 10%
July 1, 2012 8.5% 9.5%

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Floating Rate Loan: Example (2)
Amount of interest to be paid

Date of Interest Interest Rate Amount of

Payment Interest

June 30, 2011 9% INR 45,000

Dec 31, 2011 9.6% INR 48,000

June 30, 2011 10% INR 50,000

Dec 31, 2011 9.5% INR 47,500

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Interest Rates and Inflation

 Relationship provided by Irving Fisher

 Nominal interest rate = (1 + real interest rate) * (1 + expected

inflation rate) – 1

 Nominal interest rate = real rate + expected inflation rate

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Components of Interest Rate Risk

 Interest rate risk has two effects:

 Risk of changes the price of securities is called price risk

 Risk of changes in the rate at which cash flows received from

investment can be reinvested is called reinvestment rate risk

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Currency Risk

 Currency risk, or exchange rate risk, arises when cash flows are
denominated in a foreign currency

 Examples of currency risk include:

 Exporter receiving foreign currency
 Importer needing to pay foreign currency
 Investors in foreign currency securities
 Borrowers of foreign currency loans

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Approaches to Risk Management

 Do nothing

 Cover everything

 Selective hedging

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Risks in Derivative Trading
 Hedging using derivatives has its own risks
 Using futures and forwards to hedge:
 The hedger benefits only if the price moves against the hedger
(downside risk)
 The hedger could face huge losses if the price moves against
them (upside risk)
 Speculators can lose a large amount if prices move against their
expectations
 Options can also result in losses even though they provide upside
potential due to the cost of options as one needs to pay for buying
the options
 Exotic derivatives and credit derivatives result in losses due to not
understanding the nature of products

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