Derivatives and Risk Management

Introduction

Session 1 – Introduction
Prof. Aparna Bhat
What is ‘Risk’ ?
Definition of Risk
“Deviation of actual results from the expected”
What is ‘Business risk”?
Non-financial risk
Financial risk
Financial risk deals with changes in
Interest rates
Exchange rates
Commodity prices
Stock prices
Risk Management
Ways of managing risk
Risk Avoidance
Feasible?
Damage control
“loss of profit” policies etc
Diffusion of risk
Multi-location operations for disaster management
Diversification – the only free lunch in financial
markets!
Transfer of risk
Assessment of risk
How do you assess impact of risk?
Probability of adverse event occurring
Magnitude of loss
Risk Management requires classification of risks
into
High probability-Small loss events
Low probability-High loss events
Financial risks usually fall in the first category
Derivatives are effective tools to manage financial
risks
Derivatives – meaning and types
Meaning – “A financial instrument whose value
depends upon or is derived from other, more basic,
underlying variables ”
Basic types of derivatives
Forwards
Futures
Options
Swaps
Evolution of Derivatives
Said to date back to Biblical times
Forward contracts on tulip bulbs 1637 AD
Futures contracts in Yodoya rice market, Osaka,
Japan -1650 AD
Chicago Board Of Trade established in 1848
“to arrive” contracts for hedging price risk on grain
Standardization of contracts in 1865
First futures clearinghouse in 1925
Chicago Produce Exchange established in 1874
Chicago Mercantile Exchange in 1919
Evolution of Derivatives- contd.
• Period following 1970s- deregulation of markets
• End of Bretton Woods system- liberalization of exchange
rates
• First financial futures-currency futures by CME in 1972
– Followed by T-bill futures in 1975 and Eurodollar futures in
1982
– Stock Index futures by Kansas City Board of Trade in 1982
• Publication of paper on option pricing by Black and
Scholes in 1973
• Chicago Board of Options Exchange formed
• Use of computers and B-S formula
Derivatives – Classified according to
Underlying assets
 Commodities
 Earliest derivatives were on commodities
 Energy, agri-commodities and metals dominate
 Currencies
 OTC products are dominant
 USD-Rupee futures on MCX and NSE are top traded exchange-traded
 Interest rates
 Eurodollar futures and Ten-year T-Note futures top in traded volumes
 Stock Indices and individual stocks
 Kospi200 options and E-mini S&P 500 futures dominate
 Credit derivatives – OTC in nature
 Weather derivatives – CME first to create such contracts
Derivatives – Classified according to
markets
• Over-the-Counter (OTC) derivatives
• Exchange-traded derivatives
• Examples of the two
• Comparison
– Customization of contracts
– Contract design
– How traded
– Liquidity
– Ease of entry and exit
– Transparency in prices and volumes
– Counterparty risk
– Transaction costs
Derivatives statistics
OTC Exchange-traded
(H2 2019) (Dec 2019)
Foreign exchange 92177 388
Interest rates 448965 95425
Equity-linked 6874 Not compiled by BIS
Amounts represent notional principal outstanding in billions of US dollars
Source: BIS
Major derivatives exchanges - worldwide

As per number of contracts traded in millions during 2019

Evolution of Derivatives in India
• Cotton Futures Exchange started in Bombay in 1875 followed by
oilseeds and gold futures
• Options on cotton and forwards on oilseeds, sugar, spices and food
grains banned in WWII
• Forward Contracts Regulation Act 1951 banned all commodity options
and cash-settlement of forward contracts in 1952
• Forwards on all primary & essential commodities banned in 1960s
• Unofficial and unregulated equity derivatives existed in 1980s and
1990s in the form of ‘badla’ with no formal risk management systems
and no investor protection mechanism
• Harshad Mehta scam 1992
• Emergence of SEBI as equity market regulator
• Financial futures born in 2000 – Index futures on NSE and BSE
• Index options, Stock futures and stock options in 2001
• National Commodity Exchanges formed in 2002 and 2003
Timeline of introduction of
derivative products in India

Index Futures 2000

Stock Futures 2001

Index Options 2001

Stock Options 2001

Interest Rate Futures 2003

Currency Futures 2008

Bond Futures 2009

Currency Options 2010

Growth of derivatives market in India in
INR (Billion)
Stock Currency Currency Volatility
Year Index Futures Stock Futures Index Options
Options Futures Options Futures
-
2000 - 01 23.65
-
2001 - 02 214.83 515.15 37.65 251.63
-
2002 - 03 439.52 2865.33 92.46 1001.31
-
2003 - 04 5544.46 13059.39 528.16 2172.07
-
2004 - 05 7721.47 14840.56 1219.43 1688.36
-
2005 - 06 15137.55 27916.97 3384.69 1802.53
-
2006 - 07 25395.74 38309.67 7919.06 1937.95
-
2007 - 08 38206.67 75485.63 13621.11 3591.37
-
2008 - 09 35701.11 34796.42 37315.02 2292.27 1622.72
-
2009 - 10 39343.89 51952.47 80279.64 5060.65 17826.08
-
2010 - 11 43567.55 54957.57 183653.66 10303.44 32790.02 1707.86
-
2011 - 12 35779.98 40746.71 227200.32 9770.31 33784.89 12965.01
-
2012 - 13 25271.31 42238.72 227815.74 20004.27 37651.05 15093.59
21.93
2013 - 14 30852.96 49492.82 277673.41 24094.89 29408.86 10716.28
2014 - 15 41072.15 82917.66 399226.63 32825.52 0 22479.92 22.56
Over-the-counter markets in India
 Since the late 1980s banks were allowed to execute foreign
currency forward contracts based on a defined exposure and with
corporate entities as counterparties.
 The first swap deal by any Indian company dated as far back as
1984 when the Oil and Natural Gas Corporation Limited (ONGC)
entered into the swap with a foreign bank.
 In July 2003, the RBI allowed trading by banks and corporate
entities (primarily for hedging purposes) on these Currency
Options with the restriction that while banks could both write and
hold options, corporations could only buy (hold) options.
 Most of the currency options traded in India are over – the –
counter (OTC) trades though exchange based trades are also
permissible.
Over-the-counter markets in India
Interest rate options are not allowed in the market as yet
although the RBI has conducted a number of studies to
look at the feasibility of the introduction of interest rate
options, it is yet to take the final decision and make it
available in the markets.
Products such as credit derivatives, weather derivatives
and energy derivatives, particularly options with credit
options or options with weather and / or energy as the
underlying are still not allowed to be traded in India.
The only products that are allowed in India are futures
contracts on some of them, necessarily futures contracts
on some weather-related underlying and energy
underlying.
Regulators of Indian derivatives
markets
In India there are individual and independent
regulators for each of the different market segments.
Market Segments and corresponding regulators in
India Market Segment Regulator
Equity and Equity Derivatives Securities Exchange Board of India (SEBI)
Currency and Currency Derivatives (both
Reserve Bank of India (RBI)
Indian Rupee and Cross Currency)
Interest Rates and Fixed Income
Reserve Bank of India (RBI)
Derivatives
Commodity trading and Commodity
Securities Exchange Board of India (SEBI)
Derivatives
Participants in Derivatives Markets
Hedgers
Speculators
Arbitrageurs
Attitude towards risk
• Hedgers - transfer risk
• Speculators - assume risk to make profits
• Arbitrageurs - wants to make risk-less profit
Importance of speculators and arbitrageurs
Importance of derivatives markets
Facilitate Price discovery
Facilitate transfer of risk
Provide benefit of leverage
Allow efficient diversification
Lower transaction costs
Nature of risk management using
derivatives
‘Tactical’ risk management and not ‘strategic’
Short-term measures
Decisions can be taken quickly and economically
Time horizon is typically short
Hedging with derivatives
What is ‘hedging’?
Independent existence of ‘spot’ market and
‘derivatives’ market
Strong correlation between the two markets
Opposite positions in both markets offset any
adverse price movement
Criticism of derivatives
Increased volatility in spot markets
Increased bankruptcies
Increased regulation required
Derivatives disasters over the years
Failure of Barings Bank
Sumitomo Bank losses
Metalgesellschaft
Orange County Case
Failure and bail-out of LTCM