Derivatives

and
Risk Management
________ are securities whose values are determined by the
market price or interest rate of some other asset.

a. natural hedges
b. derivatives
c. call options
d. bonds
________ are securities whose values are determined by the
market price or interest rate of some other asset.

a. natural hedges
b. derivatives
c. call options
d. bonds
________ is a contract that gives its holder the right to buy (or
sell) an asset at a pre-determined price within a specified period of
time.

a. loan
b. call option
c. option
d. bonds
________ is a contract that gives its holder the right to buy (or
sell) an asset at a pre-determined price within a specified period of
time.

a. loan
b. call option
c. option
d. bonds
An example of a _______ is the risk that fluctuations in
exchange rates will result in unanticipated losses when
entering a contract with foreign customers or suppliers.

a. demand risk
b. financial risk
c. liability risk
d. pure risk
An example of a _______ is the risk that fluctuations in
exchange rates will result in unanticipated losses when
entering a contract with foreign customers or suppliers.

a. demand risk
b. financial risk
c. liability risk
d. pure risk
A contract under which one party agrees to buy a commodity at
a specific price on a specific future date and the other party
agrees to make the sale. Physical delivery occurs.

a. futures contract
b. commodity futures
c. financial futures
d. forward contract
A contract under which one party agrees to buy a commodity at
a specific price on a specific future date and the other party
agrees to make the sale. Physical delivery occurs.

a. futures contract
b. commodity futures
c. financial futures
d. forward contract
Two common types of swaps are:

a. interest swap and foreign currency

b. commodity futures and financial futures
c. interest and forward contract
d. none of the above
Two common types of swaps are:

a. interest swap and foreign currency

b. commodity futures and financial futures
c. interest and forward contract
d. none of the above
 Derivatives
and Risk Management

Group 1
 History
- 1900 Louis Bachelier’s thesis “Theorie de la Speculation”;
Brownian Motion
- 1932 First Issue of the Journal of Risk an Insurance
- 1961-1966 Treynor, Sharpe, Linter and Mossin develop the CAPM
- 1973 Option valuation formulas by Black and Scholes and Merton
- Chicago Board Options Exchange (CBOE)
- 1988 Basel I
- 1992 RiskMetrics
- 1997 CreditMetrics
- 2004 Basel II
- 2010 Basel III
 Reasons to Manage Risk

1. Debt Capacity
2. Maintaining the optimal capital budget over time
3. Financial distress
4. Comparative advantages in hedging
5. Borrowing costs
6. Tax effects
7. Compensation systems
Risk Management
and
Shareholder Value
Risk Management is a key business

“
process within both the private and
public sectors around the world. Effective
risk management and the resulting
controlled environment are central to
sound corporate governance and for this
reason, much of the law that has been
created in response to corporate
collapses and scandals, now requires
effective risk management.
What is risk
managemen
t?
 ⊙ It involves identifying
Risk
Manageme
unpredictable events that could
nt have adverse financial
consequences for a firm and
then taking actions to prevent
or minimize the damage caused
by these events.
Types of
Risks
Types of ⊙ pure risks ⊙ property risks
Risks ⊙ speculative ⊙ personnel
risks risks
⊙ demand risks ⊙ environmenta
⊙ input risks l risks
⊙ financial risks ⊙ liability risks
⊙ insurable
risks
 What is
shareholder
value?
 ⊙ The value delivered to
shareholders because of
management’s ability to grow
Sharehold sales, earnings and free cash flow
er Value over time.
⊙ A company’s shareholder value
depends on strategic decisions
made by senior management,
including ability to make wise
investments and generate a
healthy return on invested capital.
⊙ Robust risk management
adds value to your
organization because it helps
maximize shareholder value
at the same time reducing
the probability of financial
failure.
CHRONOLOGICAL
PROCESS OF
MANAGING RISK
 Establish the content by
Step 1: considering:
Establish
the ▪ The strategic context
context ▪ The organisational
context
 Step 2: Key questions to ask include:
Identify ▪ What can happen?
the ▪ How and why it can happen?
risks
▪ What is the likelihood of them
happening?
▪ What will be the consequences
of them happening?
 ⦿ Physicalrisks- personal injuries,
environmental and weather conditions,
Risks and the physical assets of the
organization
can
⦿ Financial risks – assets of the organization
be
⦿ Ethical risks – actual or potential harm

⦿ Legal risks - responsibilities imposed on

providers, participants and consumers
arising from laws
 ⦿Table 1– Likelihood scale
What is the likelihood of the risk event
occurring?
Step 3:
Analyze the
risks (and
evaluate)
Table 2 – Loss or damage impact scale

What is the loss or damage impact if the risk event occurred

(severity?)
 
oTable 3– Risk priority scale
 According to the standard, treatment
Step 4: options include:
Treat ⦿ Accepting the risk
the ⦿ Avoiding the risk
risks ⦿ Reducing the risk
⦿ Transferring the risk
⦿ Retaining the risk
⦿ Financing the risk
Whichever option you choose to treat a risk, if the risk has
rated highly you will need to carefully consider necessary
policies, procedures and strategies to treat the risk. These
will include:
⦿ what is needed to treat the risk

⦿ who has responsibility

⦿ what is the timeframe

⦿ how you will know when the risk has been

successfully managed.
 ⦿ Ongoing part of risk
Step 5 –
management
Monitor
and ⦿ Given inadequate focus
review ⦿ ensure that the important
information generated is
captured, used and maintained
⦿ an integral part of all core
business functions
Derivatives
  A contract or security that derive its value
What is from an underlying asset or from the value
a of its interest rate or market price.
Derivativ
e?  It is simply a financial instrument that
derives its value from the movement in
commodity price, foreign exchange rate
and interest rate of an underlying asset or
financial instrument
  It is use to manage financial
Purpose risk(Hedging)
of
 To protect against fluctuations in
Derivativ
es value

 To increase leverage

 To speculate on an asset’s
movements

 Reduced transaction costs

  Commodities

 Price index
Common
underlyin  Interest rate
g asset
 Exchange rate
 TYPES OF DERIVATIVE
CONTRACTS
Cuyos, Mary Xentenel C.
CHARACTERISTICS OF DERIVATIVES

• The value of the derivative changes in response

to the change in an “underlying” variable.

• The derivative requires either no initial net

investment or an initial small net investment.

• The derivative is readily settled at a future date

by a net cash payment.
FORWARD CONTRACTS
• It is an agreement where one party agrees to buy a
commodity at a specific price on a specific future
date and the other party agrees to make the sale.

• They are not traded on exchange but rather are

only traded over-the-counter.

• Physical delivery of goods occur.

• One party will default especially if the price of the

commodity changes.
FUTURES CONTRACT
• It is a contract to purchase or sell a specified
commodity at some future date at a specified price.

• They are traded in a futures exchange market.

• Physical delivery of the underlying asset is never

taken.

• They are marked to market on a daily basis.

• Two classes of futures contract: (1) Commodity

Futures and (2) Financial Futures.
OPTIONS

• It is a contract that gives the holder the right to

purchase or sell a asset at some predetermined
price within a specified period of time.

• It requires an initial small payment for protection

against unfavorable , movement in price.

• Call Option, Put Option and Long-term Equity

AnticiPation Security.
FACTORS THAT AFFECT CALL OPTION’S
VALUE

• The higher the stocks market price in relation to

the strike price, the higher the call option price.

• The higher the strike price, the lower the call

option price.

• The longer the option period, the higher the

option price.
SWAPS

• A contract between two parties agree to swap

something, generally obligations to make specified
payment streams.

• Most Swaps involve interest rates and currency.

• A private contract negotiated between the parties.

OTHER TYPES OF DERIVATIVES

• BINARY OPTIONS- contracts that provide the

owner with an all-or-nothing profit profile.

• WARRANTS- these are long dated options and are

generally traded over the counter.
 BROAD TYPES OF
DERIVATIVE CONTRACTS
DIFFERENCE BETWEEN OVER THE COUNTER
AND EXCHANGE TRADED DERIVATIVE

OVER THE COUNTER EXCHANGE TRADED

• are contracts that are traded • are those derivatives
(and privately negotiated)
instruments that are
directly between two parties,
without going through an traded via
exchange or other intermediary. specialized derivatives
exchanges or other
• A decentralized market, without exchanges.
a central physical location,
where market participants
trade with one another through • a marketplace in which
various communication modes securities, commodities,
such as the telephone, email
and proprietary electronic derivatives and other
trading systems. financial instruments are
traded.