FRM Notes

Financial Risk Management Whether we like it or not, mankind now has a completely integrated, international financial and informational
marketplace capable of moving money and ideas to any place on this planet in minutes. Believe me the secret of reaping the greatest fruitfulness and the greatest enjoyment from life is to live dangerously Friedrich Wilhelm Financial Engineering "omputational finance, also called financial engineering, is a cross#disciplinary field which relies on computational intelligence, mathematical finance, numerical methods and computer simulations to make trading, hedging and investment decisions, as well as facilitating the risk management of those decisions. $tili!ing various methods, practitioners of computational finance aim to precisely determine the financial risk that certain financial instruments create. iet!sche
%o be alive at all involve some &isk

(Harold Macmillan)
Khurasan Institute of Higher Education Jalalabad, Afghanistan.
B Imran Khan
MBA (Finance), CIA, CQC
Financial Risk Management
!hat Is Risk"
Risk is the chance of financial loss, or more formally the variability of ret rns associated !ith a "iven
asset# Risk $rovides the basis for o$$ort nity# %he terms risk and e&$os re have sli"ht differences in $ossibility of loss, altho "h they are often sed interchan"eably# Risk arises as a res lt of e&$os re# '&$os re to financial markets affects most or"ani(ations, either directly or indirectly# )hen an or"ani(ation has financial market e&$os re, there is a $ossibility of loss b t also an o$$ort nity for "ain or $rofit# Financial market e&$os re may $rovide strate"ic or com$etitive benefits# Risk is the likelihood of losses res ltin" from events s ch as chan"es in market $rices# 'vents !ith a lo! $robability of occ rrin", b t that may res lt in a hi"h loss, are $artic larly tro blesome beca se they are often not antici$ated# * t another !ay, risk is the $robable variability of ret rns# *otential +i(e of ,oss *otential for ,ar"e ,oss *otential for +mall ,oss *robability of ,oss Hi"h *robability of -cc rrence ,o! *robability of -cc rrence
their meanin"# Risk refers to the $robability of loss, !hile e&$os re (e&$erience, contact) is the
+ince it is not al!ays $ossible or desirable to eliminate risk, nderstandin" it is an im$ortant ste$ in determinin" ho! to mana"e it# Identifyin" e&$os res and risks forms the basis for an a$$ro$riate financial risk mana"ement strate"y# In#estment A commitment of f nds made in the e&$ectation of the $ositive rate of ret rns# Ret rns. investment is made !ith the aim of ret rns# Ret rns/ yield 0ca$ital a$$reciations# Risk Its inherent May be ca$ital loss -r not receivin" the interest $ayments or dividends# ,on"er mat rity hi"her risk Credit !orthiness of the firm Risk varies !ith nat re of investment#
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Return Ret rn can be defined as the total "ain or loss e&$erienced on an investment over a "iven $eriod of time#
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Risk in In#estment Investors like ret rn and dislike risk Risk in holdin" sec rities is "enerally associated !ith the $ossibility that reali(ed ret rns !ill be less than the ret rns that !ere e&$ected# Risk is the variability of the in ret rns of a sec rity Ho$ %oes Financial Risk Arise" Financial risk arises thro "h co ntless transactions of a financial nat re, incl din" sales and $ rchases, investments and loans, and vario s other b siness activities# It can arise as a res lt of le"al transactions, ne! $ro1ects, mer"ers and ac2 isitions, debt financin", the ener"y com$onent of costs, or thro "h the activities of mana"ement, stakeholders, com$etitors, forei"n "overnments, or !eather# )hen financial $rices chan"e dramatically, it can increase costs, red ce reven es, or other!ise adversely im$act the $rofitability of an or"ani(ation# Financial fl ct ations may make it more diffic lt to $lan and b d"et, $rice "oods and services, and allocate ca$ital# %here are three main so rces of financial risk. 3# Financial risks arisin" from an or"ani(ation4s e&$os re to chan"es in market $rices, s ch as interest rates, e&chan"e rates, and commodity $rices# 5# Financial risks arisin" from the actions of, and transactions !ith, other or"ani(ations s ch as vendors, c stomers, and co nter$arties in derivatives transactions 6# Financial risks res ltin" from internal actions or fail res of the or"ani(ation, $artic larly $eo$le, $rocesses, and systems# %hese are disc ssed in more detail in s bse2 ent cha$ters# !hat Is Financial Risk Management" Financial risk mana"ement is a $rocess to deal !ith the ncertainties res ltin" from financial markets# It involves assessin" the financial risks facin" an or"ani(ation and develo$in" mana"ement strate"ies consistent !ith internal $riorities and $olicies# Addressin" financial risks $roactively may $rovide an or"ani(ation !ith a com$etitive advanta"e# It also ens res that mana"ement, o$erational staff, stakeholders, and the board of directors are in a"reement on key iss es of risk# Mana"in" financial risk necessitates makin" or"ani(ational decisions abo t risks that are acce$table vers s those that are not# %he $assive strate"y of takin" no action is the acce$tance of all risks by defa lt#
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-r"ani(ations mana"e financial risk sin" a variety of strate"ies and $rod cts# It is im$ortant to nderstand ho! these $rod cts and strate"ies !ork to red ce risk !ithin the conte&t of the or"ani(ation4s risk tolerance (acce$tance) and ob1ectives#
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+trate"ies for risk mana"ement often involve derivatives# 7erivatives are traded !idely amon" financial instit tions and on or"ani(ed e&chan"es# %he val e of derivatives contracts, s ch as f t res, for!ards, rates, e&chan"e rates, commodities, e2 ity and fi&ed income sec rities, credit, and even !eather# %he $rod cts and strate"ies sed by market $artici$ants to mana"e financial risk are the same ones sed by s$ec lators to increase levera"e and risk# Altho "h it can be ar" ed that !ides$read se of derivatives increases risk, the e&istence of derivatives enables those !ho !ish to red ce risk to $ass it alon" to those !ho seek risk and its associated o$$ort nities# o$tions, and s!a$s, is derived from the $rice of the nderlyin" asset# 7erivatives trade on interest
%he ability to estimate the $ossibility of a financial loss is hi"hly desirable# Ho!ever, standard theories of $robability often fail in the analysis of financial markets# Risks s ally do not e&ist in isolation, and the interactions of several e&$os res may have to be considered in develo$in" an nderstandin" of ho! financial risk arises# +ometimes, these interactions are diffic lt to forecast, since they ltimately de$end on h man behavior# %he $rocess of financial risk mana"ement is an on"oin" one# +trate"ies need to be im$lemented and refined as the market and re2 irements chan"e# Refinements may reflect chan"in" e&$ectations abo t market rates, chan"es to the b siness environment, or chan"in" international $olitical conditions, for e&am$le# In "eneral, the $rocess can be s mmari(ed as follo!s. Identify and $rioriti(e key financial risks# 7etermine an a$$ro$riate level of risk tolerance# Im$lement risk mana"ement strate"y in accordance !ith $olicy# Meas re, re$ort, monitor, and refine as needed#
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Risk &lassification
%8*'+ -F RI+9. %h s far, o r disc ssion has concerned the total risk of an asset, !hich is one im$ortant consideration in investment analysis# Ho!ever, modern investment analysis cate"ori(es the traditional so rces of risk identified $revio sly as #ca sin" variability in ret rns into t!o
:eneral ty$es. those that are $ervasive in nat re, s ch as market risk or interest rate risk, and those that are s$ecific to a $artic lar sec rity iss e, s ch as b siness or financial risk# %herefore, !e m st consider these t!o cate"ories of total risk# 7ividin" total risk into its t!o com$onents, a "eneral (market) com$onent and a s$ecific (iss er) com$onent, !e have systematic risk and nonsystematic risk, !hich are additive. %otal risk / :eneral risk 0 +$ecific risk / Market risk 0 Iss er risk / +ystematic risk 0 ;onsystematic risk
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Risk Classification
Total Risk
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S ystematic Risk
nsystematic Risk
Market Risk
Interest Rate Risk
Purchasing Power Risk
!usiness Risk
"inancial Risk
A. ' stematic Risk +ystematic (Market) Risk, (;on<diversifiable Risk). Risk attrib table to broad macro factors affectin" all sec rities# Actin" accordin" to a fi&ed $lan or system +ystematic risk is ca sed by system !ide factors that affect the entire comm nity# Chan"e in economic conditions Chan"e in $olitical system Chan"e in social system
%he effect of s ch system !ide factors !hich are beyond the control of individ al, b siness establishments and !hich affect all the b siness establishments in the system called =+ystematic Risk>#
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+ystematic Risk is an investor can constr ct a diversified $ortfolio and eliminate $an of the total risk, the diversifiable or non<market $art# )hat is left is the non<diversifiable $ortion or the market risk# ?ariability in a sec rity@s total ret rns that is directly associated !ith overall movements in the "eneral market or economy is called systematic (market) risk# ?irt ally all sec rities have some systematic risk, !hether bonds or stocks, beca se systematic risk directly encom$asses the interest rate, market, and inflation risks# %he investor cannot esca$e this $art of the risk, beca se no matter ho! !ell he or she diversifies, the risk of the overall market cannot be avoided# If the stock market declines shar$ly, most stocks !ill be adversely affectedA if it rises stron"ly, as in the last fe! months of 3BC5, most stocks !ill a$$reciate in val e# %hese movements occ r re"ardless of !hat any sin"le investor does# Clearly, market risk is critical to all investors# (. Market Risk %his arises o t of chan"es in demand and s $$ly $ress res in the markets, follo!in" the chan"in" flo! of information or e&$ectations# %he totality of investor $erce$tion and s b1ective factors infl ence the events in the market !hich are n$redictable and "ive rise to risk, !hich is not controllable# %he basis for the reaction is a set of real, tan"ible events D$olitical, social or economic Intan"ible events are related to market $sycholo"y ). Interest Rate Risk %he ret rn on an investment de$ends on the interest rate $romised on it and chan"es in market rates of interest from time to time# %he cost of f nds borro!ed by com$anies or stockbrokers de$ends on interest rates# %he market activity and investor $erce$tion chan"e !ith the chan"es in interest rates# ,o!er interest rates make it easier for $eo$le to borro! in order to b y cars and homes# * rchases of homes, in t rn, increase the demand for other items, s ch as f rnit re and a$$liances, th s $rovidin" an additional boost to the economy# ,o!er interest rates mean that cons mers s$end less on interest costs, leavin" them !ith more of their income to s$end on "oods and services#
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*. +urchasing +o$er Risk It is also kno!n as inflation risk %his risk is arises o t of chan"e in the $rices of "oods and services and technically it covers both inflation and deflation $eriods 'nflation( &ising prices on goods and services )eflation( Falling prices on goods and services *urchasing power risk+ 'nflation , )eflation B. ,ns stematic Risk
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;onsystematic (;on<market) Risk, (7iversifiable Risk). Risk attrib table to factors ni2 e to the sec rity ;onsystematic Risk is the variability in a sec rity@s total ret rns not related to overall market variability is called the nonsystematic (non<market) risk# %his risk 3s ni2 e to a $artic lar sec rity and is associated !ith s ch factors as b siness and financial risk as !ell as li2 idity risk# Altho "h all sec rities tend to have some nonsystematic risk, it is "enerally connected !ith common stocks# Ensystematic risk emer"es o t of the kno!n and controllable factors, internal to iss er of the sec rities or com$anies# Factors s ch as mana"ement ca$ability, cons mer $references and labor strikes can ca se nsystematic variability of ret rns for a com$any4s stock# %he ncertainty s rro ndin" the ability of the iss er to make $ayments on sec rities sto$s from t!o so rces. 3# %he o$eratin" environment of the b siness< B siness Risk 5# %he financin" of the firm< Financial risk ( Business Risk %his relates to the variability of the b siness, sales, income, $rofits etc# !hich in t rn de$end on the market conditions for the $rod ct mi&, in$ t s $$lies, stren"th of com$etitors, etc# %his B siness risk is sometimes e-ternal to the com$any d e to chan"es in "ovt# $olicy or strate"ies of com$etitors or nforeseen market conditions %hey may be internal d e to fall in $rod ction, labor $roblems, ra! material $roblems or inade2 ate
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s $$ly of electricity etc# %he internal b siness risk leads to fall in reven es and in $rofit of the com$any, b t can be corrected by certain chan"es in the com$any4s $olicies# ). Financial Risk servicin" $roblems or short<term li2 idity $roblems d e to bad debts, delayed receivables and fall in c rrent assets or rise in c rrent liabilities# %hese $roblems co ld no do bt be solved, b t they may lead to fl ct ations in earnin"s, $rofits and dividends to shareholders# +ometimes, if the com$any r ns into losses or red ced $rofits, these may lead to fall in ret rns to investors or ne"ative ret rns# *ro$er financial $lannin" and other financial ad1 stments can be sed to correct this risk and as s ch it is controllable# Risk management. /ature 0 Im1ortance Risk Management D %he entire $rocess of identifyin", eval atin", controllin" and revie!in" risks, to make s re that the or"ani(ation is e&$osed to only those risks that it needs to take to achieve its $rimary ob1ectives# Risk mana"ement is *roactive ($ractical) $rocess, As different markets, different ty$es of risks so, the risk mana"ement $roced res and techni2 es vary in their a$$lication !ays b t tar"et is sameA $ ttin" the risks nder control and accom$lishin" the mission as e&$ected#
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%his relates to the method of financin", ado$ted by the com$any, hi"h levera"e leadin" to lar"er debt
!a s to &onduct Risk Management

%here can be three a$$roaches or sets of actions and !ithin them the vario s instr ments that are available to firms for risk mana"ement# Eliminate2A#oid A firm can decide to eliminate certain risks that are not consistent !ith its desired financial characteristics or not essential to a financial asset created# Moreover, the firm like a bank can se $ortfolio diversification in order to eliminate s$ecific risk# Additionally, it can decide to b y ins rance, for event risks# F rthermore, the firm can choose to avoid certain risk ty$es $ front by settin" certain b siness $racticesF$olicies (e#"#, nder!ritin" standards,
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$rocess control) to red ce the chances of certain losses andFor to eliminate certain risks e- ante# If the firm has no com$arative advanta"e in mana"in" a s$ecific kind of risk, there is no reason to absorb andFor mana"e s ch a risk# Absorb2Manage
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+ome risks m st or sho ld be absorbed and mana"ed at the firm level, beca se they have one or more of the follo!in" characteristics. %hey cannot be traded or hed"ed easily %hey have a com$le&, illi2 id, or $ro$rietary str ct re that is diffic lt, e&$ensive, or im$ossible to reveal to others %hey are a b siness necessity# +ome risks $lay a central role in the bank4s b siness $ r$ose and sho ld therefore not be eliminated or transferred 3ransfer %he transfer of risks to other market $artici$ants is decided on the basis of !hether or not the firm has
a com$etitive advanta"e in a s$ecific (risk) se"ment# Any element of the systematic risk that is not re2 ired or desired can be either shedA instr ments. %i#ersification. %he bank is s $$osed to have s $erior skills (com$etitive advanta"es), beca se it can $rovide diversification more efficientlyFat a lo!er cost than individ al investors co ld do on their o!n# %his mi"ht be the case in illi2 id areas !here shareholders cannot hed"e on their o!n# Mana"ement of their credit $ortfolio is necessary, beca se the $erformance of a credit $ortfolio is determined not only by e&o"eno s factors b t also by endo"eno s factors s ch as s $erior e- ante screenin" ca$abilities and e- post monitorin" skills# 7iversification, ty$ically, red ces the fre2 ency of both !orst<case and best<case o tcomes, !hich "enerally red ces the bank4s $robability of fail re# Holding ca1ital. For all other risks that cannot be diversified a!ay or ins red internally and !hich the bank decides to absorb, it has to make s re that it holds a s fficient amo nt of ca$ital in order to ens re that its $robability of defa lt is ke$t at a s fficiently lo! level#
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by sellin" it in the s$ot market or hed"ed by sin" derivative instr ments s ch as f t res, for!ards, or s!a$s
In all s ch circ mstances, the bank needs to actively mana"e these risks by sin" one of the follo!in"
;ote that e2 ity finance is costly %he cost of economic ca$ital and the decision of not eliminatin" risk $rovide a trade<off Both risk and ret rn need to be monitored
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In dealin" !ith the challen"e of risk mana"ement, the follo!in" interrelated guidelines sho ld be consideredA Enderstandin" the firm4s strate"ic e&$os re 'm$loyin" a mi& of real and financial tools *roactively mana"in" ncertainty Ali"nin" risk mana"ement !ith cor$orate strate"y ,earnin" !hen it is !orth red cin" risk
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Risk Management +rocess

%he $rocess of financial risk mana"ement com$rises strate"ies that enable an or"ani(ation to mana"e the risks associated !ith financial markets# Risk mana"ement is a dynamic $rocess that or"ani(ation incl din" treas ry, sales, marketin", le"al, ta&, commodity, and cor$orate finance# %he risk mana"ement $rocess involves both internal and e&ternal analysis# %he first $art of the $rocess involves identifyin" and $rioriti(in" the financial risks facin" an or"ani(ation and nderstandin" their relevance# It may be necessary to e&amine the or"ani(ation and its $rod cts, mana"ement, c stomers, s $$liers, com$etitors, $ricin", ind stry trends, balance sheet str ct re, and $osition in the ind stry# It is also necessary to consider stakeholders and their ob1ectives and tolerance for risk# -nce a clear nderstandin" of the risks emer"es, a$$ro$riate strate"ies can be im$lemented in con1 nction !ith risk mana"ement $olicy# For e&am$le, it mi"ht be $ossible to chan"e !here and ho! b siness is done, thereby red cin" the or"ani(ation4s e&$os re and risk# Alternatively, e&istin" e&$os res may be mana"ed !ith derivatives# Another strate"y for mana"in" risk is to acce$t all risks and the $ossibility of losses# %here are three broad alternatives for mana"in" risk. 7o nothin" and actively, or $assively by defa lt, acce$t all risks# Hed"e a $ortion of e&$os res by determinin" !hich e&$os res can and sho ld be hed"ed# Hed"e all e&$os res $ossible# Meas rement and re$ortin" of risks $rovides decision makers !ith information to e&ec te decisions and monitor o tcomes, both before and after strate"ies are taken to miti"ate them# +ince the risk mana"ement $rocess is on"oin", re$ortin" and feedback can be sed to refine the system by modifyin" or im$rovin" strate"ies# An active decision<makin" $rocess is an im$ortant com$onent of risk mana"ement# 7ecisions abo t $otential loss and risk red ction $rovide a for m for disc ssion of im$ortant iss es and the varyin" $ers$ectives of stakeholders# sho ld evolve !ith an or"ani(ation and its b siness# It involves and im$acts many $arts of an
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Factors that Im1act Financial Rates and +rices

Financial rates and $rices are affected by a n mber of factors# It is essential to nderstand the factors that im$act markets beca se those factors, in t rn, im$act the $otential risk of an or"ani(ation# A Factors that Affect Interest Rates
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Interest rates are a key com$onent in many market $rices and an im$ortant economic barometer# %hey are com$rised of the real rate $l s a com$onent for e&$ected inflation, since inflation red ces the $ rchasin" $o!er of a lender4s assets# %he "reater the term to mat rity, the "reater the ncertainty# Interest rates are also reflective of s $$ly and demand for f nds and credit risk# Interest rates are $artic larly im$ortant to com$anies and "overnments beca se they are the key in"redient in the cost of ca$ital# Most com$anies and "overnments re2 ire debt financin" for e&$ansion and ca$ital $ro1ects# )hen interest rates increase, the im$act can be si"nificant on borro!ers# Interest rates also affect $rices in other financial markets, so their im$act is far< reachin"# -ther com$onents to the interest rate may incl de a risk $remi m to reflect the credit!orthiness of a borro!er# For e&am$le, the threat of $olitical or soverei"n risk can ca se interest rates to rise, sometimes s bstantially, as investors demand additional com$ensation for the increased risk of defa lt# Factors that infl ence the level of market interest rates incl de. '&$ected levels of inflation :eneral economic conditions Monetary $olicy and the stance of the central bank Forei"n investor demand for debt sec rities ,evels of soverei"n debt o tstandin" Financial and $olitical stability
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Factors that Affect Foreign E-change Rates
Forei"n e&chan"e rates are determined by s $$ly and demand for c rrencies# + $$ly and demand, in t rn, are infl enced by factors in the economy, forei"n trade, and the activities of international
investors# Ca$ital flo!s, "iven their si(e and mobility, are of "reat im$ortance in determinin" e&chan"e rates# Factors that infl ence the level of interest rates also infl ence e&chan"e rates amon" floatin" or market<determined c rrencies# C rrencies are very sensitive to chan"es or antici$ated chan"es in interest rates and to soverei"n risk factors# +ome of the key drivers that affect e&chan"e rates incl de. G Interest rate differentials net of e&$ected inflation G %radin" activity in other c rrencies G International ca$ital and trade flo!s G International instit tional investor sentiment G Financial and $olitical stability G Monetary $olicy and the central bank G 7omestic debt levels (e#"#, debt<to<:7* ratio) G 'conomic f ndamentals
&
Factors that Affect &ommodit +rices
*hysical commodity $rices are infl enced by s $$ly and demand# Enlike financial assets, the val e of commodities is also affected by attrib tes s ch as $hysical 2 ality and location# Commodity s $$ly is a f nction of $rod ction# + $$ly may be red ced if $roblems !ith $rod ction or delivery occ r, s ch as cro$ fail res or labor dis$ tes# In some commodities, seasonal variations of s $$ly and demand are s al and shorta"es are not ncommon#
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7emand for commodities may be affected if final cons mers are able to obtain s bstit tes at a lo!er cost# %here may also be ma1or shifts in cons mer taste over the lon" term if there are s $$ly or cost iss es# Commodity traders are sensitive to the inclination of certain commodity $rices to vary accordin" to the sta"e of the economic cycle# For e&am$le, base metals $rices may rise late in the economic monitored as a form of leadin" indicator# Commodity $rices may be affected by a n mber of factors, incl din". G '&$ected levels of inflation, $artic larly for $recio s metals G Interest rates G '&chan"e rates, de$endin" on ho! $rices are determined G :eneral economic conditions G Costs of $rod ction and ability to deliver to b yers G Availability of s bstit tes and shifts in taste and cons m$tion $atterns G )eather, $artic larly for a"ric lt ral commodities and ener"y G *olitical stability, $artic larly for ener"y and $recio s metals
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cycle as a res lt of increased economic demand and e&$ansion# *rices of these commodities are
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&alculation of Return
)e are "oin" to assess risk on the basis of variability of ret rn, !e need to be certain !e kno! !hat ret rn is and ho! to meas re it# %he ret rn is the total "ain or loss e&$erienced on an investment over a "iven $eriod of time# It is commonly meas re as cash distrib tions d rin" the $eriod $l s the chan"e in val e e&$ressed as a $ercenta"e of the be"innin" of $eriod investment val e# %he e&$ression for calc latin" the rate of ret rn earned on any asset over $eriod, commonly defined as.
C 0 *C < *B *B
!here. i C *B *C / / / / rate of ret rn cash flo! received from the investment $rice (val e) of asset at be"innin" $rice (val e) of asset after chan"es
'&am$le. Mr# Moody !ishes to determine the ret rn of t!o video machines, C and 7# C !as $ rchased 3 year a"o for H 5I,III and c rrently has a market val e of H 53,JII# 7 rin" the year it "enerated H CII of after ta& cash recei$ts# 7 !as $ rchased K years a"o, its val e in the year 1 st com$leted declined from mH 35,III to H 33,CII# 7 rin" the year it "enerated H 3,LII of after ta& cash recei$ts# )e can calc late the ann al rate of ret rn i for each video machine# For video machine C i / C 0 *C < *B
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*B i / CII 0 53,JII < 5I,III

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5I,III i / 5,6II 5I,III i / 33#JM
For video machine 7 i / C 0 *C < *B *B i / 3,LII 0 33,CII < 35,III 35,III
3,JII 35,III
35#JM
Altho "h the market val e of 7 declined d rin" the year, its cash flo! ca sed it to earn hi"her rate of ret rn than C earned d rin" the same $eriod# Clearly the combined im$act of cash flo! chan"es in val e as meas red by the rate of ret rn is im$ortant#
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Risk +references
Feelin"s abo t risk differ amon" mana"ers and firms# %h s it is im$ortant to s$ecify a "enerally
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acce$table level of risk# %he three basic risk $reference behaviors risk averse, risk indifferent and risk seekin" are e&$lained belo!. A Risk Indifferent
Risk Indifferent is the attit de to!ard risk in !hich no chan"e in ret rn !o ld be re2 ired for an increase risk# For the risk indifferent mana"er the re2 ired ret rn does not chan"e as risk "oes from &3 to &5# In essence no chan"e in ret rn !o ld be re2 ired for the increase in risk# B Risk A#erse
It is the attit de to!ard risk in !hich increased ret rn !o ld be re2 ired for an increase in risk# For the risk averse mana"er the re2 ired ret rn increases for an increase in risk# Beca se they shy a!ay from risk, these mana"ers re2 ire e&$ected ret rns to com$ensate them for takin" "reater risk# & Risk 'eeking
Risk seekin" is the attit de to!ard risk in !hich a decreased ret rn !o ld be acce$ted for an increase in risk# For the risk seekin" mana"er, the re2 ired ret rn decreases for an increase in risk# %heoretically beca se they en1oy risk these mana"ers are !illin" to "ive $ some ret rn to take more risk# Ho!ever s ch behavior !o ld not be likely to benefit the firm# Most mana"ers are risk averseA for a "iven increase in risk they re2 ire an increase in ret rn# %hey "enerally tend to be conservative rather than a""ressive hen acce$tin" risk for their firm# Accordin"ly a risk averse financial mana"er re2 irin" hi"her ret rns for "reater risk is ass med thro "ho t this te&t#
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Risk of a single asset %he conce$t of risk can be develo$ed by first considerin" a sin"le asset held in isolation# )e can look at e&$ected ret rn behaviors to assess risk, and statistics can be sed to meas re it# Risk Assessment +ensitivity analysis and $robability distrib tions can be sed to assess the "eneral level of risk embodied in a "iven asset# 'ensiti#it anal sis An a$$roach for assessin" risk that ses several $ossible ret rn estimates to obtain a sense of the variability amon" o tcomes# +ensitivity analysis ses several $ossible ret rn estimates to obtain a sense of the variability amon" o tcomes# -ne common method involve s makin" $essimistic !orst, most likely e&$ected and o$timistic best estimates of the ret rns associated !ith a "iven asset# In this case the assets risk can be meas red by the ran"e of ret rns# %he ran"e is fo nd by s btractin" the $essimistic o tcome from the o$timistic o tcome# %he "reater the ran"e the more variability or risk the asset is said to have# E-am1le ;orman com$any a "olf e2 i$ment man fact rer, !ants to choose the better t!o investments, A and B# each re2 ires an initial o tlay of Rs# 3I,III and each has a most likely ann al rate of ret rn of 3JM# Mana"ement has made $essimistic an o$timistic estimates of the ret rns associated !ith each# %he three estimates for each asset alon" !ith its ran"e are "iven belo!. Assets A and B Asset A Initial Investment Ann al rate of ret rn *essimistic Most likely -$timistic Ran"e
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Asset B Rs 3II,III
Rs 3II,III
36M 3JM 3LM KM
LM 3JM 56M 3NM
Asset A a$$ears to be less risky than asset B, its ran"e of K $ercent (3LM < 36M) is less than the ran"e of 3NM (56M < LM) for asset B# the risk averse decision maker !o ld $refer asset A over asset B, beca se A offers the same most likely ret rn as B 3JM !ith lo!er risk smaller ran"e#
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Altho "h the se of sensitivity analysis and the ran"e is rather cr de, it does "ive the decision maker a feel for the behavior of ret rns, !hich can be sed to estimate the risk involved# +robabilit %istributions *robability means the chance that a "iven o tcome !ill occ r# *robability distrib tions $rovide a more 2 antitative insi"ht into an assets risk# %he $robability of a "iven o tcome is its chance of occ rrin"# An o tcome !ith an CIM $robability of occ rrence !o ld be e&$ected to occ r C o t of 3I times# An o tcome !ith a $robability of 3II $ercent is certain to occ r# - tcomes !ith a $robability of (ero !ill never occ r# A $robability distrib tion is a model that relates $robabilities to the associated o tcomes# %he sim$lest ty$e of $robability distrib tion is the bar chart, !hich sho!s only a limited n mber of o tcome $robability coordinates# %he bar charts for ;orman com$any4s assets A and B are sho! in the follo!in" fi" re# Altho "h both assets have the same most likely ret rn, the ran"e of ret rn is m ch "reater or more dis$ersed for asset B than for asset A< 3N $ercent vers s K $ercent# Bar charts for asset A4s and B4s ret rns &ontinuous 1robabilit distribution A $robability distrib tion sho!in" all the $ossible o tcomes and associated $robabilities for a "iven event# If !e kne! all the $ossible o tcomes and associated $robabilities, !e co ld develo$ a contin o s $robability distrib tion# %his ty$e of distrib tion can be tho "ht of as a bar chart for a very lar"e n mber of o tcomes# Follo!in" fi" re re$resents contin o s $robability distrib tions for assets A and B# note that altho "h assets A and B have the same most likely ret rn 3JM, the distrib tion of ret rns for asset B has m ch "reater dis$ersion than the distrib tion for asset A# clearly asset B is more risky than asset A# Risk of a +ortfolio
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In real !orld sit ations, the risk of any sin"le investment !o ld not be vie!ed inde$endently of other assets# )e did so for teachin" $ r$oses# ;e! investments m st be considered in li"ht of their im$act on the risk and ret rn of the $ortfolio of assets# %he financial mana"er4s "oal is to create an efficient $ortfolio, one that ma&imi(es ret rn for a "iven level of risk or minimi(es risk for a "iven level of ret rn# )e therefore need a !ay to meas re the ret rn and the standard deviation of a $ortfolio of assets# -nce !e can do that !e !ill look at the statistical conce$t of correlation, !hich nderlies the $rocess of diversification that is sed to develo$ an efficient $ortfolio# Efficient 1ortfolio A $ortfolio that ma&imi(es ret rn for a "iven level of risk or minimi(es risk for a "iven level of ret rn# &orrelation A statistical meas re of the relationshi$ bet!een any t!o series of n mbers re$resentin" data of any kind# %he n mbers may re$resent data of any kind from ret rns to test scores# +ositi#el correlated If t!o series move in the same direction they are $ositively correlated# -r describes t!o series that move in the same direction# /egati#el correlated If the series move in o$$osite directions they are ne"atively correlated# -r describes t!o series that move in o$$osite directions# Hedging and &orrelation Hed"in" is the b siness of seekin" assets or events that offset, or have !eak or ne"ative correlation to, an or"ani(ation4s financial e&$os res# Correlation meas res the tendency of t!o assets to move, or not move, to"ether# %his tendency is 2 antified by a coefficient bet!een <3 and 03# Correlation of 03#I si"nifies $erfect $ositive correlation and means that t!o assets can be e&$ected to move to"ether# Correlation of <3#I si"nifies $erfect ne"ative correlation, !hich means that t!o assets can be e&$ected to move to"ether b t in o$$osite directions#
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%he conce$t of ne"ative correlation is central to hed"in" and risk mana"ement# Risk mana"ement involves $airin" a financial e&$os re !ith an instr ment or strate"y that is ne"atively correlated to the e&$os re#
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A lon" f t res contract sed to hed"e a short nderlyin" e&$os re em$loys the conce$t of ne"ative correlation# If the $rice of the nderlyin" (short) e&$os re be"ins to rise, the val e of the (lon") f t res contract !ill also increase, offsettin" some or all of the losses that occ r# %he e&tent of
the $rotection offered by the hed"e de$ends on the de"ree of ne"ative correlation bet!een the t!o#
%eri#ati#es
%efinition of %eri#ati#es
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-ne of the most si"nificant events in the sec rities markets has been the develo$ment and e&$ansion of financial derivatives# %he term =derivatives> is sed to refer to financial
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instr ments !hich derive their val e from some nderlyin" assets# %he nderlyin" assets co ld be e2 ities (shares), debt (bonds, %<bills, and notes), c rrencies, and even indices of these vario s assets, s ch as the ;ifty JI Inde&# 7erivatives derive their names from their res$ective and so on# 7erivatives can be traded either on a re" lated e&chan"e, s ch as the ;+' or off the
nderlyin" asset# %h s if a derivative4s nderlyin" asset is e2 ity, it is called e2 ity derivative e&chan"es, i#e#, directly bet!een the different $arties, !hich is called =over<the<co nter> (-%C) tradin"# %he basic $ r$ose of derivatives is to transfer the $rice risk (inherent in fl ct ations of the asset $rices) from one $arty to anotherA they facilitate the allocation of risk to those !ho are !illin" to take it# In so doin", derivatives hel$ miti"ate the risk arisin" from the f t re ncertainty of $rices# For e&am$le, on ;ovember 3, 5IIB a rice farmer may !ish to sell his harvest at a f t re date (say Oan ary 3, 5I3I) for a $re<determined fi&ed $rice to eliminate the risk of chan"e in $rices by that date# + ch a transaction is an e&am$le of a derivatives contract# %he $rice of this derivative is driven by the s$ot $rice of rice !hich is the P nderlyin"P# 4rigin of deri#ati#es )hile tradin" in derivatives $rod cts has "ro!n tremendo sly in recent times, the earliest evidence of these ty$es of instr ments can be traced back to ancient :reece# 'ven tho "h derivatives have been in e&istence in some form or the other since ancient times, the advent of modern day derivatives contracts is attrib ted to farmers4 need to $rotect themselves a"ainst a decline in cro$ $rices d e to vario s economic and environmental factors# %h s, derivatives contracts initially develo$ed in commodities# %he first =f t res> contracts can be traced to the 8odoya rice market in -saka, Oa$an aro nd 3NJI# %he farmers !ere afraid of rice $rices fallin" in the f t re at the time of harvestin"# %o lock in a $rice (that is, to sell the rice at a $redetermined fi&ed $rice in the f t re), the farmers entered into contracts !ith the b yers# %hese !ere evidently standardi(ed contracts, m ch like today4s f t res contracts# In 3CKC, the Chica"o Board of %rade (CB-%) !as established to facilitate tradin" of for!ard contracts on vario s commodities# From then on, f t res contracts on commodities have remained more or less in the same form, as !e kno! them today# )hile the basics of derivatives are the same for all assets
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s ch as e2 ities, bonds, c rrencies, and commodities, !e !ill foc s on derivatives in the e2 ity markets and all e&am$les that !e disc ss !ill se stocks and inde& (basket of stocks)# 3$o im1ortant terms Before disc ssin" derivatives, it !o ld be sef l to be familiar !ith t!o terminolo"ies relatin" to the nderlyin" markets# %hese are as follo!s. '1ot Market In the conte&t of sec rities, the s$ot market or cash market is a sec rities market in !hich sec rities are sold for cash and delivered immediately# %he delivery ha$$ens after the settlement $eriod# ,et s describe this in the conte&t of India# %he ;+'4s cash market se"ment is kno!n as the Ca$ital Market (CM) +e"ment# Inde+tock $rices fl ct ate contin o sly d rin" any "iven $eriod# *rices of some stocks mi"ht move $ !hile that of others may move do!n# In s ch a sit ation, !hat can !e say abo t the stock market as a !holeQ Has the market moved $ or has it moved do!n d rin" a "iven $eriodQ +imilarly, have stocks of a $artic lar sector moved $ or do!nQ %o identify the "eneral trend in the market (or any "iven sector of the market s ch as bankin"), it is im$ortant to have a reference barometer !hich can be monitored# Market $artici$ants se vario s indices for this $ r$ose# An inde& is a basket of identified stocks, and its val e is com$ ted by takin" the !ei"hted avera"e of the $rices of the constit ent stocks of the inde&# A market inde& for e&am$le consists of a "ro $ of to$ stocks traded in the market and its val e chan"es as the $rices of its constit ent stocks chan"e# %efinitions of Basic %eri#ati#es %here are vario s ty$es of derivatives traded on e&chan"es across the !orld# %hey ran"e from the very sim$le to the most com$le& $rod cts# %he follo!in" are the three basic forms of derivatives, !hich are the b ildin" blocks for many com$le& derivatives instr ments (the latter are beyond the sco$e of this book). Forwards
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Futures Options
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Swaps 9no!led"e of these instr ments is necessary in order to nderstand the basics of derivatives# )e shall no! disc ss each of them in detail# A For$ards
A for!ard contract or sim$ly a for!ard is a contract bet!een t!o $arties to b y or sell an asset at a certain f t re date for a certain $rice that is $re<decided on the date of the contract# %he f t re date is referred to as e&$iry date and the $re<decided $rice is referred to as For!ard *rice# It may be noted that For!ards are $rivate contracts and their terms are determined by the $arties involved# A for!ard contract is a $artic larly sim$le derivative# It is an a"reement to b y or sell an asset at a certain f t re time at a certain $rice# It can be contrasted !ith a s$ot contract, !hich is an a"reement to b y or sell an asset today# A for!ard contract is traded in the over<the<co nter market, s ally bet!een t!o
Rnancial instit tions or bet!een a Rnancial instit tion and one of its clients# -ne of the $arties to a for!ard contract ass mes a lon" $osition and a"rees to b y the nderlyin" asset on a certain s$eciRed f t re date for a certain s$eciRed $rice# %he other $arty ass mes a short $osition and a"rees to sell the nderlyin" asset on the same for the same $rice# %he $rice in a for!ard contract is kno!n as the delivery $rice# For!ard contracts are commonly sed to hed"e forei"n c rrency risk#
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A for!ard is th s an a"reement bet!een t!o $arties in !hich one $arty, the b yer, enters into an a"reement !ith the other $arty, the seller that he !o ld b y from the seller an nderlyin" asset on the e&$iry date at the for!ard $rice# %herefore, it is a commitment by both the $arties to en"a"e in a transaction at a later date !ith the $rice set in advance# %his is different from a s$ot that a"rees to b y the asset on a f t re date is referred to as a lon" investor and is said to have a lon" $osition# +imilarly the $arty that a"rees to sell the asset in a f t re date is referred to as a short investor and is said to have a short $osition# %he $rice a"reed $on is called the delivery $rice or the For!ard *rice# For!ard contracts are traded only in -ver the Co nter (-%C) market and not in stock e&chan"es# -%C market is a $rivate market !here individ alsFinstit tions can trade thro "h ne"otiations on a one to one basis#
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market contract, !hich involves immediate $ayment and immediate transfer of asset# %he $arty
'&am$le 3.
(Hed"in" C rrency Risk !ith a For!ard Contract)
+ $$ose it is A$ril J of a certain year and the treas rer of a E#+# Cor$oration kno!s that the cor$oration !ill receive 3 million 'ER-s in three months (on O ly Jth), and !ants to hed"e a"ainst the e&chan"e rate moves# %he treas rer co ld contact a bank, and Rnd o t that the e&chan"e rate for a 6<month for!ard contract on 'ER- is H3#5J, and a"ree to sell 3 million 'ER-s# In this case, the cor$oration takes a short for!ard $osition (a"rees to sell), !hereas the bank ass mes a lon" for!ard $osition (a"rees to b y)# %his for!ard contract eliminates all e&chan"e rate risk, since the cor$oration !ill receive H3#5J million no matter !hat ha$$ens to the ' ro c rrency rate in the co rse of the ne&t three months# 'ettlement of for$ard contracts )hen a for!ard contract e&$ires, there are t!o alternate arran"ements $ossible to settle the obli"ation of the $arties. $hysical settlement and cash settlement# Both ty$es of settlements ha$$en on the e&$iry date and are "iven belo!# +h sical 'ettlement A for!ard contract can be settled by the $hysical delivery of the nderlyin" asset by a short investor (i#e# the seller) to the lon" investor (i#e# the b yer) and the $ayment of the a"reed
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for!ard $rice by the b yer to the seller on the a"reed settlement date# %he follo!in" e&am$le !ill hel$ s nderstand the $hysical settlement $rocess# E-am1le II Consider t!o $arties (A and B) enter into a for!ard contract on 3 A " st, 5IIB !here, A a"rees to deliver 3III stocks of Enitech to B, at a $rice of Rs# 3II $er share, on 5B the A " st, 5IIB (the e&$iry date)# In this contract, A, !ho has committed to sell 3III stocks of Enitech at Rs# 3II $er share on 5B the A " st, 5IIB has a short $osition and B, !ho has committed to b y 3III stocks at Rs# 3II $er share is said to have a lon" $osition# In case of $hysical settlement, on 5Bth A " st, 5IIB (e&$iry date), A has to act ally deliver 3III Enitech shares to B and B has to $ay the $rice (3III S Rs# 3II / Rs# 3I,III) to A# Incase A does not have 3III shares to deliver on 5Bth A " st, 5IIB, he has to $ rchase it from the s$ot market and then deliver the stocks to B# -n the e&$iry date the $rofitFloss for each $arty de$ends on the settlement $rice, that is, the closin" $rice in the s$ot market on 5B A " st, 5IIB# %he closin" $rice on any "iven day is the !ei"hted avera"e $rice of the nderlyin" d rin" the last half an ho r of tradin" in that day# 7e$endin" on the closin" $rice, three different scenarios of $rofitFloss are $ossible for each $arty# %hey are as follo!s. 'cenario I Closin" s$ot $rice on 5B A " st, 5IIB (+ %) is "reater than the For!ard $rice
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(F%) Ass me that the closin" $rice of Enitech on the settlement date 5B A " st, 5IIB is Rs# 3IJ# +ince the short investor has sold Enitech at Rs# 3II in the For!ard market on 3 A " st, 5IIB, he can b y 3III Enitech shares at Rs# 3IJ from the market and deliver them to the lon" investor# %herefore the $erson !ho has a short $osition makes a loss of (3II D 3IJ) T 3III / Rs# JIII# If the lon" investor sells the shares in the s$ot market immediately after receivin" them, he !o ld make an e2 ivalent $rofit of (3IJ D 3II) T 3III / Rs# JIII# 'cenario II Closin" +$ot $rice on 5B A " st (+ %), 5IIB is the same as the For!ard $rice
(F%) %he short seller !ill b y the stock from the market at Rs# 3II and "ive it to the lon" investor# As the settlement $rice is same as the For!ard $rice, neither $arty !ill "ain or lose anythin"#
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'cenario III Closin" +$ot $rice (+ %) on 5B A " st is less than t he f t res $rice (F %) Ass me that the closin" $rice of Enitech on 5B A " st, 5IIB is Rs# BJ# %he short investor, !ho has sold Enitech at Rs# 3II in the For!ard market on 3 A " st, 5IIB, !ill b y the stock from the market at Rs# BJ and deliver it to the lon" investor# %herefore the $erson !ho has a short $osition !o ld make a $rofit of (3II D BJ) T 3III / Rs# JIII and the $erson !ho has lon" $osition in the contract !ill lose an e2 ivalent amo nt (Rs# JIII), if he sells the shares in the s$ot market immediately after receivin" them# %he main disadvanta"e of $hysical settlement is that it res lts in h "e transaction costs in terms of act al $ rchase of sec rities by the $arty holdin" a short $osition (in this case A) and transfer of the sec rity to the $arty in the lon" $osition (in this case B)# F rther, if the $arty in the lon" $osition is act ally not interested in holdin" the sec rity, then she !ill have to inc r f rther transaction cost in dis$osin" off the sec rity# An alternative !ay of settlement, !hich hel$s in minimi(in" this cost, is thro "h cash settlement#
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&ash 'ettlement Cash settlement does not involve act al delivery or recei$t of the sec rity# 'ach $arty either $ays (receives) cash e2 al to the net loss ($rofit) arisin" o t of their res$ective $osition in the contract# +o, in case of +cenario I mentioned above, !here the s$ot $rice at the e&$iry date (+%) !as "reater than the for!ard $rice (F%), the $arty !ith the short $osition !ill have to $ay an amo nt e2 ivalent to the net loss to the $art y at the lon" $osition# In o r e&am$le, A !ill sim$ly $ay Rs# JIII to B on the e&$iry date# %he o$$osite is the case in +cenario (III), !hen +% U F%# %he lon" $arty !ill be at a loss and have to $ay an amo nt e2 ivalent to the net loss to the short $arty# In o r e&am$le, B !ill have to $ay Rs# JIII to A on the e&$iry date# In case of +cenario (II) !here + % / F%, there is no need for any $arty to $ay anythin" to the other $arty# *lease note that the $rofit and loss $osition in case of $hysical settlement and cash settlement is the same e&ce$t for the transaction costs !hich is involved in the $hysical settlement#
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%efault risk in for$ard contracts A dra!back of for!ard contracts is that they are s b1ect to defa lt risk# Re"ardless of !hether the contract is for $hysical or cash settlement, there e&ists a $otential for one $arty to defa lt, i#e# not honor the contract# It co ld be either the b yer or the seller# %his res lts in the other $arty s fferin" a loss# %his risk of makin" losses d e to any of the t!o $arties defa ltin" is kno!n as co nter $arty risk# %he main reason behind s ch risk is the absence of any mediator bet!een the $arties, !ho co ld have ndertaken the task of ens rin" that both the $arties f lfill their obli"ations arisin" o t of the contract# 7efa lt risk is also referred to as co nter $arty risk or credit risk# For$ard +rices and Arbitrage Arbitra"e involves lockin" in a $roRt by sim ltaneo sly enterin" into transactions in t!o or more markets to e&$loit a $ricin" anomaly# + ch o$$ort nities to make riskless $roRts are 2 ite rare, since !hen the traders start movin" to e&$loit them the $rices ad1 st accordin"ly so that the arbitra"e o$$ort nity disa$$ears#
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E-am1le III (Arbitra"e !ith a For!ard Contract on :old)# %his e&am$le ill strates the $ossibility of arbitra"e !hen the delivery $rice on a for!ard contract is too hi"h or too lo!# Consider a trader !ho o!ns one o nce of "old today# + $$ose the s$ot $rices for "old is s ch that in the s$ot market traders can b y an o nce of "old at *B / H3II and sell at *+ / HBJ# F rthermore, s $$ose that the 3<year borro!in" and lendin" rates are s ch that traders can borro! at RB / JM and lend at R, / KM a year# + $$ose Rrst that the delivery $rice for a one year for!ard contract on "old is F / H3IL# In this case, the follo!in" arbitra"e strate"y yields a riskless $roRt# Borro! H3II at JM, b y one o nce of "old in the s$ot market and take a short $osition in the for!ard contract#
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%o see !hy, note that at time of delivery for the for!ard, the trader !ill sell the "old she bo "ht for H3IL, !hereas she has to $ay back the loan at H3II(30I#IJ) / H3IJ, !hich leaves her !ith H3IL V H3IJ / H5 $roRts# ;ote that once traders start e&$loitin" this arbitra"e o$$ort nity by takin" short for!ard $ositions, there !ill be an e&cess s $$ly to deliver "old at H3IL, !hich !ill drive the 3<year "old for!ard delivery $rice do!n# For the arbitra"e o$$ort nity to disa$$ear, the delivery $rice F sho ld be less than F U *B (3 0 RB) / H3II(3 0 I#IJ) / H3IJ F U H3IJ# E-am1le III (contin ed)
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+ $$ose no! that the delivery $rice for a one year for!ard contract on "old is F / HBN# In this case, the follo!in" arbitra"e strate"y yields a riskless $roRt (recall that o r trader o!n one o nce of "old to be"in !ith)# +ell the "old today at *+ / HBJ, lend the $roceeds at R, / KM, and take a ,-;: $osition in the for!ard contract# %o see !hy, note that at time of delivery for the for!ard contract, the trader !ill BE8 the "old at F / HBN, !hereas she !ill receive HBJ(3 0 I#IK) / HBC#C (for the f nds she invested at KM), !hich leaves her !ith HBC#C V HBN / H5#C $roRts# ;ote that once traders start e&$loitin" this arbitra"e o$$ort nity by takin" lon" for!ard $ositions, there !ill be an e&cess demand to be delivered "old at HBN, !hich !ill drive the 3<year "old for!ard delivery $rice $# For the arbitra"e o$$ort nity to disa$$ear, the delivery $rice F sho ld be more than F W *+ (3 0 R,) / HBJ(3 0 I#IK) / HBC#C F W HBC#C
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+ractice +roblems +roblem ( A E#+# Com$any e&$ects to $ay 3 million ' ros in si& months# Ho! can they se
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for!ard contracts to hed"e a"ainst the e&chan"e rate riskQ +roblem ) strate"y# +roblem * %he $rice of "old is c rrently HJII $er o nce# %he for!ard $rice for delivery in
one year is HLII# An arbitra"e trader can borro! money at 3IM $er ann m# Identify an arbitra"e
A traders o!ns one nit of "old# %he trader can b y "old at HJI $er o nce and sell
it at HKI $er o nce in the s$ot market# +he can borro! money at NM $er year and can invest money at JM $er year# For !hat ran"e of one<year "old for!ard $rice F does this trader have no arbitra"e o$$ort nitiesQ
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Futures
201213
,ike a for!ard contract, a f t res contract is an a"reement bet!een t!o $arties in !hich the b yer a"rees to b y an nderlyin" asset from the seller, at a f t re date at a $rice that is a"reed
$on today# Ho!ever, nlike a for!ard contract, a f t res contract is not a $rivate transaction b t "ets traded on a reco"ni(ed stock e&chan"e# In addition, a f t res contract is standardi(ed by the e&chan"e# All the terms, other than the $rice, are set by the stock e&chan"e (rather than by individ al $arties as in the case of a for!ard contract)# Also, both b yer and seller of the f t res contracts are $rotected a"ainst the co nter $arty risk by an entity called the Clearin" Cor$oration# %he Clearin" Cor$oration $rovides this " arantee to ens re that the b yer or the seller of a f t res contract does not s ffer as a res lt of the co nter $arty defa ltin" on its obli"ation# In case one of the $arties defa lts, the Clearin" Cor$oration ste$s in to f lfill the obli"ation of this $arty, so that the other $arty does not s ffer d e to non<f lfillment of the contract# %o be able to " arantee the f lfillment of the obli"ations nder the contract, the Clearin" Cor$oration holds an amo nt as a sec rity from both the $arties# %his amo nt is called the Mar"in money and can be in the form of cash or other financial assets# Also, since the f t res contracts are traded on the stock e&chan"es, the $arties have the fle&ibility of closin" o t the contract $rior to the mat rity by s2 arin" off the transactions in the market# %he basic flo! of a transaction bet!een three $arties, namely B yer, +eller and Clearin" Cor$oration is de$icted in the dia"ram belo!.
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)hat is the difference bet!een for!ard and f t res contractsQ F ndamentally, for!ard and f t res contracts have the same f nction. both ty$es of contracts allo! $eo$le to b y or sell a s$ecific ty$e of asset at a s$ecific time at a "iven $rice# For!ards *rivately ne"otiated contracts ;ot standardi(ed +ettlement dates can be set by the $arties F t res %raded on an e&chan"e +tandardi(ed contracts Fi&ed settlement dates as declared by the e&chan"e Hi"h co nter $arty risk Almost no co nter $arty risk
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&
41tions
,ike for!ards and f t res, o$tions are derivative instr ments that $rovide the o$$ort nity to b y or sell an nderlyin" asset on a f t re date# An o$tion is a derivative contract bet!een a b yer and a seller, !here one $arty (say First *arty) "ives to the other (say +econd *arty) the ri"ht, b t not the obli"ation, to b y from (or sell to) the First *arty the nderlyin" asset on or before a s$ecific day at an a"reed < $on $rice# In ret rn for "rantin" the o$tion, the $arty "rantin" the o$tion collects a $ayment from the other $arty# %his $ayment collected is called the =$remi m> or $rice of the o$tion# %he ri"ht to b y or sell is held by the =o$tion b yer> (also called the o$tion holder)A the $arty "rantin" the ri"ht is t he =o$tion seller> or =o$tion !riter># Enlike for!ards and f t res contracts, o$tions re2 ire a cash $ayment (called the $remi m) $front from the o$tion b yer to the o$tion seller# %his $ayment is called o$tion $remi m or o$tion $rice# -$tions can be traded either on the stock e&chan"e or in over the co nter (-%C) markets# -$tions traded on the e&chan"es are backed by the Clearin" Cor$oration thereby minimi(in" the risk arisin" d e to defa lt by the co nter $arties involved# %here are t!o ty$es of o$tions, call o$tions and $ t o$tions, !hich are e&$lained belo!. &all o1tion A call o$tion is an o$tion "rantin" the ri"ht to the b yer of the o$tion to b y the nderlyin" asset on a s$ecific day at an a"reed $on $rice, b t not the obli"ation to do so# It is the seller !ho "rants this ri"ht to the b yer of the o$tion# It may be noted that the $erson !ho has the ri"ht to b y the nderlyin" asset is kno!n as the =b yer of the call o$tion># %he $rice at !hich the b yer has the ri"ht to b y the asset is a"reed $on at the time of enterin" the contract# %his $rice is kno!n as the strike $rice of the contract (call o$tion strike $rice in this case)# +ince the b yer of the call o$tion has the ri"ht (b t no obli"ation) to b y the nderlyin" asset, he !ill e&ercise his ri"ht to b y the nderlyin" asset if and only if the $rice of the nderlyin" asset in the market is more than the strike $rice on or before the e&$iry date of the contract# %he b yer of the call o$tion does not have an obli"ation to b y if he does not !ant to#
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+ut o1tion A $ t o$tion is a contract "rantin" the ri"ht to the b yer of the o$tion to sell the nderlyin" asset on or before a s$ecific day at an a"reed $on $rice, b t not the obli"ation to do so# It is the seller !ho "rants this ri"ht to the b yer of the o$tion# %he $erson !ho has the ri"ht to sell the nderlyin" asset is kno!n as the =b yer of the $ t o$tion># %he $rice at !hich the b yer has the ri"ht to sell the asset is a"reed $on at the time of enterin" the contract# %his $rice is kno!n as the strike $rice of the contract ($ t o$tion strike $rice in this case)# +ince the b yer of the $ t o$tion has the ri"ht (b t not the obli"ation) to sell the nderlyin" asset, he !ill e&ercise his ri"ht to sell the nderlyin" asset if and only if the $rice of the nderlyin" asset in the market is less than the strike $rice on or before the e&$iry date of the contract# %he b yer of the $ t o$tion does not have the obli"ation to sell if he does not !ant to# Ill stration + $$ose A has =bo "ht a call o$tion> of 5III shares of Enilever at a strike $rice of Rs 5NI $er share at a $remi m of Rs 3I# %his o$tion "ives A, the b yer of the o$tion, the ri"ht to b y 5III shares of Enilever from the seller of the o$tion, on or before A " st 5L, 5IIB (e&$iry date of the o$tion)# %he seller of the o$tion has the obli"ation to sell 5III shares of Enilever at Rs 5NI $er share on or before A " st 5L, 5IIB (i#e# !henever asked by the b yer of the o$tion)# + $$ose instead of b yin" a call, A has =sold a $ t o$tion> on 3II Reliance Ind stries (RI,) shares at a strike $rice of Rs 5III at a $remi m of Rs C# %his o$tion is an obli"ation to A to b y 3II shares of Reliance Ind stries (RI,) at a $rice of Rs 5III $er share on or before A " st 5L (e&$iry date of the o$tion) i#e#, as and !hen asked by the b yer of the $ t o$tion# It de$ends on the o$tion b yer as to !hen he e&ercises the o$tion# As stated earlier, the b yer does not have the obli"ation to e&ercise the o$tion#
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%ifferences bet$een futures and o1tions.
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3erminolog of %eri#ati#es In this section !e e&$lain the "eneral terms and conce$ts related to derivatives# '1ot 1rice 5'36 +$ot $rice of an nderlyin" asset is the $rice that is 2 oted for immediate delivery of the asset# For e&am$le, at the ;ational +tock '&chan"e of India (;+'), the s$ot $rice of Reliance ,td# at any "iven time is the $rice at !hich Reliance ,td# shares are bein" traded at that time in the Cash Market +e"ment of the ;+'# +$ot $rice is also referred to as cash $rice sometimes# For$ard 1rice or futures 1rice 5F6
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For!ard $rice or f t res $rice is the $rice that is a"reed $on at the date of the contract for the delivery of an asset at a s$ecific f t re date# %hese $rices are de$endent on the s$ot $rice, the $revailin" interest rate and the e&$iry date of the contract# 'trike 1rice 5K6 %he $rice at !hich the b yer of an o$tion can b y the stock (in the case of a call o$tion) or sell the stock (in the case of a $ t o$tion) on or before the e&$iry date of o$tion contracts is called strike $rice# It is the $rice at !hich the stock !ill be bo "ht or sold !hen the o$tion is e&ercised# +trike $rice is sed in the case of o$tions onlyA it is not sed for f t res or for!ards# E-1iration date 536 In the case of F t res, For!ards and Inde& -$tions, '&$iration 7ate is the only date on !hich settlement takes $lace# In case of stock o$tions, on the other hand, '&$iration date (or sim$ly e&$iry), is the last date on !hich the o$tion can be e&ercised# It is also called the final settlement date# &ontract si7e As f t res and o$tions are standardi(ed contracts traded on an e&chan"e, they have a fi&ed contract si(e# -ne contract of a derivatives instr ment re$resents a certain n mber of shares of the nderlyin" asset# For e&am$le, if one contract of BH', consists of 6II shares of BH',, then if one b ys one f t res contract of BH',, then for every Re 3 increase in BH',4s f t res $rice, the b yer !ill make a $rofit of 6II T 3 / Rs 6II and for every Re 3 fall in BH',4s f t res $rice, he !ill lose Rs 6II# &ontract 8alue Contract val e is notional val e of the transaction in case one contract is bo "ht or sold# It is the contract si(e m lti$lied b t the $rice of the f t res# Contract val e is sed to calc late mar"ins etc# for contracts# In the e&am$le above if BH', f t res are tradin" at Rs# 5III the contract val e !o ld be Rs# 5III & 6II / Rs# N lacs#
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Margins
201213
In the s$ot market, the b yer of a stock has to $ay the entire transaction amo nt (for $ rchasin" the stock) to the seller# For e&am$le, if Infosys is tradin" at Rs# 5III a share and an investor %he settlement !ill take $lace on %05 basisA that is, t!o days after the transaction date# In a derivatives contract, a $erson enters into a trade today (b y or sell) b t the settlement ha$$ens on a f t re date# Beca se of this, there is a hi"h $ossibility of defa lt by any of the $arties# F t res and o$tion contracts are traded thro "h e&chan"es and the co nter $arty risk is taken care of by the clearin" cor$oration# In order to $revent any of the $arties from defa ltin" on his trade commitment, the clearin" cor$oration levies a mar"in on the b yer as !ell as seller of the f t res and o$tion contracts# %his mar"in is a $ercenta"e (a$$ro&imately 5IM) of the total contract val e# %h s, for the aforementioned e&am$le, if a $erson !ants to b y 3II Infosys f t res, then he !ill have to $ay 5IM of the contract val e of Rs 5,II,III / Rs KI,III as a mar"in to the clearin" cor$oration# %his mar"in is a$$licable to both, the b yer and the seller of a f t res contract#
!ants to b y 3II Infosys shares, then he has to $ay Rs# 5III T 3II / Rs# 5,II,III to the seller#
Mone ness of an 41tion =Moneyness> of an o$tion indicates !hether an o$tion is !orth e&ercisin" or not i#e# if the o$tion is e&ercised by the b yer of the o$tion !hether he !ill receive money or not# =Moneyness> of an o$tion at any "iven time de$ends on !here the s$ot $rice of the nderlyin" is at that $oint of time relative to the strike $rice# %he $remi m $aid is not taken into consideration !hile calc latin" moneyness of an -$tion, since the $remi m once $aid is a s nk cost and the $rofitability from e&ercisin" the o$tion does not de$end on the si(e of the $remi m# %herefore, the decision (of the b yer of the o$tion) !hether to e&ercise the o$tion or not is not affected by the si(e of the $remi m# %he follo!in" three terms are sed to define the moneyness of an o$tion#
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In9the9mone o1tion
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An o$tion is said to be in<the<money if on e&ercisin" the o$tion, it !o ld $rod ce a cash inflo! for the b yer# %h s, Call -$tions are in<the<money !hen the val e of s$ot $rice of the nderlyin" e&ceeds the strike $rice# -n the other hand, * t -$t ions are in<the< money !hen the
s$ot $rice of the nderlyin" is lo!er than the strike $rice# Moneyness of an o$tion sho ld not be conf sed !ith the $rofit and loss arisin" from holdin" an o$tion contract# It sho ld be noted that !hile moneyness of an o$tion does not de$end on the $remi m $aid, $rofitFloss do# %h s a holder of an in<the<money o$tion need not al!ays make $rofit as the $rofitability also de$ends on the $remi m $aid# 4ut9of9 the9mone o1tion An o t<of<the<money o$tion is an o$$osite of an in<the<money o$tion# An o$tion<holder !ill not e&ercise the o$tion !hen it is o t<of<the<money# A Call o$tion is o t<of<the<money !hen its strike $rice is "reater than the s$ot $rice of the nderlyin" and a * t o$tion is o t<of<the<money !hen the s$ot $rice of the nderlyin" is "reater than the o$tion4s strike $rice# At9 the9mone o1tion An at<the<money<o$tion is one in !hich the s$ot $rice of the nderlyin" is e2 al to the strike $rice# It is at the sta"e !here !ith any movement in the s$ot $rice of the nderlyin", the o$tion !ill either become in<the<money or o t<of<the<money# Illustration Consider some Call and * t o$tions on stock T8X# As on 36 A " st, 5IIB, T8X is tradin" at Rs 33N#5J# %he table belo! "ives the information on closin" $rices of fo r o$tions, e&$irin" in +e$tember and 7ecember, and !ith strike $rices of Rs# 33J and Rs# 33L#JI#
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Mone ness of call and 1ut o1tions

201213
+ $$ose the s$ot $rice of the nderlyin" (closin" share $rice) as at end of +e$tember is Rs# 33N and at end of 7ecember is Rs# 33C# -n the basis of the r les stated above, !hich o$tions is in< the<money and !hich ones is o t<of<the<money are "iven in the follo!in" table# Mone ness of call and 1ut o1tions
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It may be noted that an o$tion !hich is in<the<money at a $artic lar instance may t rn into o t< of<theD money (and vice versa) at another instance d e to chan"e in the $rice of the nderlyin" asset#
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A11lications of %eri#ati#es
)e look at the $artici$ants in the derivatives markets and ho! they se derivatives contracts# +artici1ants in the %eri#ati#es Market As e2 ity markets develo$ed, different cate"ories of investors started $artici$atin" in the market# '2 ity market $artici$ants c rrently incl de retail investors, cor$orate investors, m t al f nds, banks, forei"n instit tional investors etc# 'ach of these investor cate"ories ses the derivatives market to as a $art of risk mana"ement, investment strate"y or s$ec lation# Based on the a$$lications that derivatives are $ t to, these investors can be broadly classified into three "ro $s. Hedgers '1eculators, and Arbitrageurs )e shall no! look at each of these cate"ories in detail# ( Hedgers
%hese investors have a $osition (i#e#, have bo "ht stocks) in the nderlyin" market b t are !orried abo t a $otential loss arisin" o t of a chan"e in the asset $rice in the f t re# Hed"ers $artici$ate in the derivatives market to lock the $rices at !hich they !ill be able to transact in the f t re# %h s, they try to avoid $rice risk thro "h holdin" a $osition in the derivatives market# 7ifferent hed"ers take different $ositions in the derivatives market based on their e&$os re in the nderlyin" market# A hed"er normally takes an o$$osite $osition in the derivatives market to !hat he has in the nderlyin" market# Hed"in" in f t res market can be done thro "h t!o $ositions, vi(# short hed"e and lon" hed"e#
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'hort Hedge A short hed"e involves takin" a short $osition in the f t res market# +hort hed"e $osition is taken by someone !ho already o!ns the nderlyin" asset or is e&$ectin" a f t re recei$t of the nderlyin" asset# For e&am$le, an investor holdin" Reliance shares may be !orried abo t adverse f t re $rice movements and may !ant to hed"e the $rice risk# He can do so by holdin" a short $osition in the derivatives market# %he investor can "o short in Reliance f t res at the ;+'# %his $rotects him from $rice movements in Reliance stock# In case the $rice of Reliance shares falls, the investor !ill lose money in the shares b t !ill make $ for this loss by the "ain made in Reliance F t res# ;ote that a short $osition holder in a f t res contract makes a $rofit if the $rice of the nderlyin" asset falls in the f t re# In this !ay, f t res contract allo!s an investor to mana"e his $rice risk# +imilarly, a s "ar man fact rin" com$any co ld hed"e a"ainst any $robable loss in the f t re d e to a fall in the $rices of s "ar by holdin" a short $osition i n the f t resF for!ards market# If the $rices of s "ar fall, the com$any may lose on the s "ar sale b t the loss !ill be offset by $rofit made in the f t res contract# :ong Hedge A lon" hed"e involves holdin" a lon" $osition in the f t res market# A ,on" $osition holder a"rees to b y the nderlyin" asset at the e&$iry date by $ayin" the a"reed f t resF for!ard $rice# %his strate"y is sed by those !ho !ill need to ac2 ire the nderlyin" asset in the f t re# For e&am$le, a chocolate man fact rer !ho needs to ac2 ire s "ar in the f t re !ill be !orried abo t any loss that may arise if the $rice of s "ar increases in the f t re# %o hed"e a"ainst this risk, the chocolate man fact rer can hold a lon" $osition in the s "ar f t res# If the $rice of s "ar rises, the chocolate man fact re may have to $ay more to ac2 ire s "ar in the normal market, b t he !ill be com$ensated a"ainst this loss thro "h a $rofit that !ill arise in the f t res market# ;ote that a lon" $osition holder in a f t res contract makes a $rofit if the $rice of the nderlyin" asset increases in the f t re# ,on" hed"e strate"y can also be sed by those investors !ho desire to $ rchase the nderlyin" asset at a f t re date (that is, !hen he ac2 ires the cash to
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$ rchase the asset) b t !ants to lock the $revailin" $rice in the market# %his may be beca se he thinks that the $revailin" $rice is very lo!# For e&am$le, s $$ose the c rrent s$ot $rice of )i$ro ,td# is Rs# 5JI $er stock# An investor is e&$ectin" to have Rs# 5JI at the end of the month# %he investor feels that )i$ro ,td# is at a very attractive level and he may miss the o$$ort nity to b y the stock if he !aits till the end of the month# In s ch a case, he can b y )i$ro ,td# in the f t res market# By doin" so, he can lock in the $rice of the stock# Ass min" that he b ys )i$ro ,td# in the f t res market at Rs# 5JI (this becomes his locked<in $rice), there can be three $robable scenarios. 'cenario I. *rice of )i$ro ,td# in the cash market on e&$iry date is Rs# 6II# As f t res $rice
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is e2 al to the s$ot $rice on the e&$iry day, the f t res $rice of )i$ro !o ld be at Rs# 6II on e&$iry day# %he investor can sell )i$ro ,td in the f t res market at Rs# 6II# By doin" this, he has made a $rofit of 6II D 5JI / Rs# JI in the f t res trade# He can no! b y )i$ro ,td in the s$ot market at Rs# 6II# %herefore, his total investment cost for b yin" one share of )i$ro ,td e2 als Rs#6II ($rice in s$ot market) D JI ($rofit in f t res market) / Rs#5JI# %his is the amo nt of money he !as e&$ectin" to have at the end of the month# If the investor had not bo "ht )i$ro ,td f t res, he !o ld have had only Rs# 5JI and !o ld have been nable to b y )i$ro ,td shares in the cash market# %he f t res contract hel$ed him to lock in a $rice for the shares at Rs# 5JI# 'cenario II. *rice of )i$ro ,td in the cash market on e&$iry day is Rs# 5JI# As f t res $rice tracks s$ot $rice, f t res $rice !o ld also be at Rs# 5JI on e&$iry day# %he investor !ill sell )i$ro ,td in the f t res market at Rs# 5JI# By doin" this, he has made Rs# I in the f t res trade# He can b y )i$ro ,td in the s$ot market at Rs# 5JI# His total investment cost for b yin" one share of )i$ro !ill be / Rs# 5JI ($rice in s$ot market) 0 I (loss in f t res market) / Rs# 5JI# 'cenario III. *rice of )i$ro ,td in the cash market on e&$iry day is Rs# 5II# As f t res $rice tracks s$ot $rice, f t res $rice !o ld also be at Rs# 5II on e&$iry day# %he investor !ill sell )i$ro ,td in the f t res market at Rs# 5II# By doin" this, he has made a loss of 5II D 5JI / Rs# JI in the f t res trade# He can b y )i$ro in the s$ot market at Rs# 5II# %herefore, his total investment cost for b yin" one share of )i$ro ,td !ill be / 5II ($rice in s$ot market) 0 JI (loss
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in f t res market) / Rs# 5JI# %h s, in all the three scenarios, he has to $ay only Rs# 5JI# %his is an e&am$le of a ,on" Hed"e# ) '1eculators
201213
A +$ec lator is one !ho bets on the derivatives market based on his vie!s on the $otential movement of the nderlyin" stock $rice# +$ec lators take lar"e, calc lated risks as they trade based on antici$ated f t re $rice movements# %hey ho$e to make 2 ick, lar"e "ainsA b t may not al!ays be s ccessf l# %hey normally have shorter holdin" time for their $ositions as com$ared to
hed"ers# If the $rice of the nderlyin" moves as $er their e&$ectation they can make lar"e $rofits# Ho!ever, if the $rice moves in the o$$osite direction of their assessment, the losses can also be enormo s# Illustration C rrently ICICI Bank ,td (ICICI) is tradin" at, say, Rs# JII in the cash market and also at Rs# JII in the f t res market (ass med val es for the e&am$le only)# A s$ec lator feels that $ost the RBI4s $olicy anno ncement, the share $rice of ICICI !ill "o $# %he s$ec lator can b y the stock in the s$ot market or in the derivatives market# If the derivatives contract si(e of ICICI is 3III and if the s$ec lator b ys one f t res contract of ICICI, he is b yin" ICICI f t res !orth Rs JII T 3III / Rs# J,II,III# For this he !ill have to $ay a mar"in of say 5IM of the contract val e to the e&chan"e# %he mar"in that the s$ec lator needs to $ay to the e&chan"e is 5IM of Rs# J,II,III / Rs# 3,II,III# %his Rs# 3,II,III is his total investment for the f t res contract# If the s$ec lator !o ld have invested Rs# 3,II,III in the s$ot market, he co ld $ rchase only 3,II,III F JII / 5II shares# ,et s ass me that $ost RBI anno ncement $rice of ICICI share moves to Rs# J5I# )ith one lakh investment each in the f t res and the cash market, the $rofits !o ld be. (J5I D JII) T 3,III / Rs# 5I,III in case of f t res market and (J5I D JII) T 5II / Rs# KIII in the case of cash market# It sho ld be noted that the o$$osite !ill res lt in case of adverse movement in stock $rices, !herein the s$ec lator !ill be losin" more in the f t res market than in the s$ot market# %his is beca se the s$ec lator can hold a lar"er $osition in the f t res market !here he has to $ay only the mar"in money#
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Arbitrageurs
Arbitra"e rs attem$t to $rofit from $ricin" inefficiencies in the market by makin" sim ltaneo s trades that offset each other and ca$t res a risk<free $rofit# An arbitra"e r may also seek to make $rofit in case there is $rice discre$ancy bet!een the stock $rice in the cash and the derivatives markets# For e&am$le, if on 3st A " st, 5IIB the +BI share is tradin" at Rs# 3LCI in the cash market and the f t res contract of +BI is tradin" at Rs# 3LBI, the arbitra"e r !o ld b y the +BI shares (i#e# make an investment of Rs# 3LCI) in the s$ot market and sell the same n mber of +BI f t res contracts# -n e&$iry day (say 5K A " st, 5IIB), the $rice of +BI f t res contracts !ill close at the $rice at !hich +BI closes in the s$ot market# In other !ords, the settlement of the f t res contract !ill ha$$en at the closin" $rice of the +BI shares and that is !hy the f t res and s$ot $r ices are said to conver"e on the e&$iry day# -n e&$iry day, the arbitra"e r !ill sell the +BI stock in the s$ot market and b y the f t res contract, both of !hich !ill ha$$en at the closin" $rice of +BI in the s$ot market# +ince the arbitra"e r has entered into off<settin" $ositions, he !ill be able to earn Rs# 3I irres$ective of the $revailin" market $rice on the e&$iry date# %here are three $ossible $rice scenarios at !hich +BI can close on e&$iry day# ,et s calc late the $rofitF loss of the arbitra"e r in each of the scenarios !here he had initially (3 A " st) $ rchased +BI shares in the s$ot market at Rs 3LCI and sold the f t res contract of +BI at Rs# 3LBI. 'cenario I. +BI shares closes at a $rice "reater than 3LCI (say Rs# 5III) in the s$ot market
201213
on e&$iry day (5K A " st 5IIB) +BI f t res !ill close at the same $rice as +BI in s$ot market on the e&$iry day i#e#, +BI f t res !ill also close at Rs# 5III# %he arbitra"e r reverses his $revio s transaction entered into on 3 A " st 5IIB# *rofitF ,oss (D) in s$ot market / 5III D 3LCI / Rs# 55I *rofitF ,oss (D) in f t res market / 3LBI D 5III / Rs# (D) 53I ;et $rofitF ,oss (D) on both transactions combined / 55I D 53I / Rs# 3I $rofit#
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'cenario II. +BI shares close at Rs 3LCI in the s$ot market on e&$iry day (5K A " st 5IIB) +BI f t res !ill close at the same $rice as +BI in s$ot market on e&$iry day i#e#, +BI f t res !ill also close at Rs 3LCI# %he arbitra"e r reverses his $revio s transaction entered into on 3 A " st 5IIB# *rofitF ,oss (D) in s$ot market / 3LCI D 3LCI / Rs I *rofitF ,oss (D) in f t res market / 3LBI D 3LCI / Rs# 3I ;et $rofitF ,oss (D) on both transactions combined / I 0 3I / Rs# 3I $rofit# 'cenario III. +BI shares close at Rs# 3JII in the s$ot market on e&$iry day (5K A " st 5IIB), Here also, +BI f t res !ill close at Rs# 3JII# %he arbitra"e r reverses his $revio s transaction entered into on 3 A " st 5IIB# *rofitF ,oss (D) in s$ot market / 3JII D 3LCI / Rs# (D) 5CI *rofitF ,oss (D) in f t res market / 3LBI D 3JII / Rs# 5BI ;et $rofitF ,oss (D) on both transactions combined / (D) 5CI 0 5BI / Rs# 3I $rofit# %h s, in all three scenarios, the arbitra"e r !ill make a $rofit of Rs# 3I, !hich !as the difference bet!een the s$ot $rice of +BI and f t res $rice of +BI, !hen the transaction !as entered into# %his is called a =risk less $rofit> since once the transaction is entered into on 3 A " st, 5IIB (d e to the $rice difference bet!een s$ot and f t res), the $rofit is locked# Irres$ective of !here the nderlyin" share $rice closes on the e&$iry date of the contract, a $rofit of Rs# 3I is ass red# %he investment made by the arbitra"e r is Rs# 3LCI (!hen he b ys +BI in the s$ot market)# He makes this investment on 3 A " st 5IIB and "ets a ret rn of Rs# 3I on this investment in 56 days (5K A " st)# %his means a ret rn of I#JNM in 56 days# If !e ann ali(e this, it is a ret rn of nearly BM $er ann m# -ne sho ld also note that this o$$ort nity to make a risk<less ret rn of BM $er ann m !ill not al!ays remain# %he difference bet!een the s$ot and f t res $rice arose d e to some inefficiency (in the market), !hich !as e&$loited by the arbitra"e r by b yin" shares in s$ot and sellin" f t res# As more and more s ch arbitra"e trades take $lace, the difference bet!een s$ot and f t res $rices !o ld narro! thereby red cin" the attractiveness of f rther arbitra"e#
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201213
,ses of %eri#ati#es
( Risk management
201213
%he most im$ortant $ r$ose of the derivatives market is risk mana"ement# Risk mana"ement for an investor com$rises of the follo!in" three $rocesses. Identifyin" the desired level of risk that the investor is !illin" to take on his investmentsA Identifyin" and meas rin" the act al level of risk that the investor is carryin"A and Makin" arran"ements !hich may incl de tradin" (b yin"Fsellin") of derivatives contracts that allo! him to match the act al and desired levels of risk# %he e&am$le of hed"in" disc ssed above ill strates the $rocess of risk mana"ement thro "h f t res# ) Market efficienc
'fficient markets are fair and com$etitive and do not allo! an investor to make risk free $rofits# 7erivatives assist in im$rovin" the efficiency of the markets, by $rovidin" a self<correctin" mechanism# Arbitra"e rs are one section of market $artici$ants !ho trade !henever there is an o$$ort nity to make risk free $rofits till the o$$ort nity ceases to e&ist# Risk free $rofits are not easy to make in more efficient markets# )hen tradin" occ rs, there is a $ossibility that some amo nt of mis$ricin" mi"ht occ r in the markets# %he arbitra"e rs ste$ in to take advanta"e of this mis$ricin" by b yin" from the chea$er market and sellin" in the hi"her market# %heir actions 2 ickly narro! the $rices and thereby red cin" the inefficiencies# * +rice disco#er
-ne of the $rimary f nctions of derivatives markets is $rice discovery# %hey $rovide val able information abo t the $rices and e&$ected $rice fl ct ations of the nderlyin" assets in t!o !ays. First, many of these assets are traded in markets in different "eo"ra$hical locations# Beca se of this, assets may be traded at different $rices in different markets# In derivatives markets, the $rice of the contract often serves as a $ro&y for the $rice of the nderlyin" asset# For e&am$le, "old
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may trade at different $rices in M mbai and 7elhi b t a derivatives contract on "old !o ld have one val e and so traders in M mbai and 7elhi can validate the $rices of s$ot markets in their res$ective location to see if it is chea$ or e&$ensive and trade accordin"ly# +econd, the $rices of the f t res contracts serve as $rices that can be sed to "et a sense of the market e&$ectation of f t re $rices# For e&am$le, say there is a com$any that $rod ces s "ar and e&$ects that the $rod ction of s "ar !ill take t!o months from today# As s "ar $rices fl ct ate daily, the com$any does not kno! if after t!o months the $rice of s "ar !ill be hi"her or lo!er than it is today# Ho! does it $redict !here the $rice of s "ar !ill be in f t reQ It can do this by monitorin" $rices of derivatives contract on s "ar (say a + "ar For!ard contract)# If the for!ard $rice of s "ar is tradin" hi"her than the s$ot $rice that means that the market is e&$ectin" the s "ar s$ot $rice to "o $ in f t re# If there !ere no derivatives $rice, it !o ld have to !ait for t!o months before kno!in" the market $rice of s "ar on that day# Based on derivatives $rice the mana"ement of the s "ar com$any can make strate"ic and tactical decisions of ho! m ch s "ar to $rod ce and !hen#
201213
3rading 41tions In this cha$ter !e !ill disc ss $ay <o ts for vario s strate"ies sin" o$tions and strate"ies !hich can be sed to im$rove ret rns by sin" o$tions# 41tion +a out %here are t!o sides to every o$tion contract# -n the one side is the o$tion b yer !ho has taken a lon" $osition (i#e#, has bo "ht the o$tion)# -n the other side is the o$tion seller !ho has taken a short $osition (i#e#, has sold the o$tion)# %he seller of the o$tion receives a $remi m from the b yer of the o$tion# It may be noted that !hile com$ tin" $rofit and loss, $remi m has to be taken into consideration# Also, !hen a b yer makes $rofit, the seller makes a loss of e2 al ma"nit de and vice versa# In this section, !e !ill disc ss $ayo ts for vario s strate"ies sin" o$tions#
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A long 1osition in a call o1tion

201213
In this strate"y, the investor has the ri"ht to b y the asset in the f t re at a $redetermined strike $rice i#e#, strike $rice (9) and the o$tion seller has the obli"ation to sell the asset at the strike $rice (9)# If the settlement $rice ( nderlyin" stock closin" $rice) of the asset is above the strike $rice, then the call o$tion b yer !ill e&ercise his o$tion and b y the stock at the strike $rice (9)#
If the settlement $rice ( nderlyin" stock closin" $rice) is lo!er than the strike $rice, the o$tion b yer !ill not e&ercise the o$tion as he can b y the same stock from the market at a $rice lo!er than the strike $rice# A long 1osition in a 1ut o1tion In this strate"y, the investor has bo "ht the ri"ht to sell the nderlyin" asset in the f t re at a $redetermined strike $rice (9)# If the settlement $rice ( nderlyin" stock closin" $rice) at mat rity is lo!er than the strike $rice, then the $ t o$tion holder !ill e&ercise his o$tion and sell the stock at the strike $rice (9)# If the settlement $rice ( nderlyin" stock closin" $rice) is hi"her than the strike $rice, the o$tion b yer !ill not e&ercise the o$tion as he can sell the same stock in the market at a $rice hi"her than the strike $rice# A short 1osition in a call o1tion In this strate"y, the o$tion seller has an obli"ation to sell the asset at a $redetermined strike $rice (9) if the b yer of the o$tion chooses to e&ercise the o$tion# %he b yer of the o$tion !ill e&ercise the o$tion if the s$ot $rice at mat rity is any val e hi"her than (9)# If the s$ot $rice is lo!er than (9), the b yer of the o$tion !ill not e&ercise hisFher o$tion# A short 1osition in a 1ut o1tion In this strate"y, the o$tion seller has an obli"ation to b y the asset at a $redetermined strike $rice (9) if the b yer of the o$tion chooses to e&ercise hisFher o$tion# %he b yer of the o$tion !ill e&ercise his o$tion to sell at (9) if the s$ot $rice at mat rity is lo!er than (9)# If the s$ot $rice is hi"her than (9), then the o$tion b yer !ill not e&ercise hisFher o$tion# '&$lanation of $ay<offs for lon" o$tions
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%he b yer4s $rofit is e2 al to the seller4s loss# %herefore, in the above table the seller4s loss is + % D 9 for a short call o$tion if the s$ot $rice closes at a val e above the strike $rice of the o$tion and is 9 D+ % for a short $ t o$tion if the s$ot $rice closes at a val e lo!er than the strike $rice of the o$tion# %he above fo r $ositions and their $ay<offs are de$icted in the fi" re belo!. *ay <off for a b yer of a call o$tion
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%he fi" re sho!s the $rofitsFlosses for a b yer of a three<month ;ifty 55JI call o$tion# As can be seen, as the s$ot ;ifty rises, the call o$tion is in<the<money# If $on e&$iration, ;ifty closes above the strike of 55JI, the b yer !o ld e&ercise his o$tion and $rofit to the e&tent of the difference bet!een the ;ifty<close and the strike $rice# %he $rofits $ossible on this o$tion are $otentially nlimited# Ho!ever, if ;ifty falls belo! the strike of 55JI, the b yer lets the o$tion e&$ire# His losses are limited to the e&tent of the $remi m that he $aid for b yin" the o$tion# *ay<off for a seller of o$tion
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%he fi" re sho!s the $rofitsFlosses for a seller of a three<month ;ifty 55JI call o$tion# As the s$ot ;ifty rises, the call o$tion is in<the<money and the !riter starts makin" losses# If $on e&$iration, ;ifty closes above the strike of 55JI, the b yer !o ld e&ercise his o$tion on the !riter !ho !o ld s ffer a loss to the e&tent of the difference bet!een the ;ifty<close and the strike $rice# %he loss that can be inc rred by the !riter of the o$tion is $otentially nlimited, !hereas the ma&im m $rofit is limited to the e&tent of the $front o$tion $remi m char"ed by him# *ay<off for a b yer of a $ t o$tion
201213
%he fi" re sho!s the $rofitsFlosses for a b yer of a three<month ;ifty 55JI $ t o$tion# As can be seen, as the s$ot ;ifty falls, the $ t o$tion is in<the<money# If $on e&$iration, ;ifty closes belo! the strike of 55JI, the b yer !o ld e&ercise his o$tion and $rofit to the e&tent of the difference bet!een the strike $rice and ;ifty<close# %he $rofits $ossible on this o$tion can be as hi"h as the strike $rice# Ho!ever, if ;ifty rises above the strike of 55JI, he lets the o$tion e&$ire# His losses are limited to the e&tent of the $remi m he $aid for b yin" the o$tion# *ay<off for a seller of a $ t o$tion
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%he fi" re sho!s the $rofitsFlosses for a seller of a three<month ;ifty 55JI $ t o$tion# As the s$ot ;ifty falls, the $ t o$tion is in<the<money and the !riter starts makin" losses# If $on e&$iration, ;ifty closes belo! the strike of 55JI, the b yer !o ld e&ercise his o$tion on the !riter !ho !o ld s ffer a loss to the e&tent of the difference bet!een the strike $rice and ;ifty< close# %he loss that can be inc rred by the !riter of the o$tion is a ma&im m e&tent of the strike $rice (since the !orst that can ha$$en is that the asset $rice can fall to (ero) !hereas the ma&im m $rofit is limited to the e&tent of the $front o$tion $remi m of char"ed by him# 41tion 'trategies An o$tion strate"y is im$lemented to try and make "ains from the movement in the nderlyin" $rice of an asset# As disc ssed above, o$tions are derivatives that "ive the b yer the ri"ht to e&ercise the o$tion at a f t re date# Enlike f t res and for!ards !hich have linear $ay <offs and do not re2 ire an initial o tlay ( $front $ayment), o$tions have non linear $ay<offs and do re2 ire an initial o tlay (or $remi m)# In this section !e disc ss vario s strate"ies !hich can be sed to ma&imi(e ret rns by sin" o$tions# A :ong o1tion strateg
A lon" o$tion strate"y is a strate"y of b yin" an o$tion accordin" to the vie! on f t re $rice movement of the nderlyin"# A $erson !ith a b llish o$inion on the nderlyin" !ill b y a call o$tion on that assetFsec rity, !hile a $erson !ith a bearish o$inion on the nderlyin" !ill b y a $ t o$tion on that assetFsec rity# An im$ortant characteristic of lon" o$tion strate"ies is limited
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risk and nlimited $rofit $otential# An o$tion b yer can only lose the amo nt $aid for the o$tion $remi m# At the same time, theoretically, the $rofit $otential is nlimited# Calls An investor havin" a b llish o$inion on nderlyin" can e&$ect to have $ositive ret rns by b yin" a call o$tion on that assetFsec rity# )hen a call o$tion is $ rchased, the call o$tion holder is e&$osed to the stock $erformance in the s$ot market !itho t act ally $ossessin" the stock and does so for a fraction of the cost involved i n $ rchasin" the stock in the s$ot market# %he cost inc rred by the call o$tion holder is the o$tion $remi m# %h s, he can take advanta"e of a smaller investment and ma&imi(e his $rofits# Consider the $ rchase of a call o$tion at the $rice ($remi m) c# )e take + % / +$ot $rice at time % 9 / +trike $rice %he $ayo t in t!o scenarios is as follo!s. *rofitF,oss / D c , if + % / 9 *rofitF,oss / (+ % < 9 ) D c if + % / 9 ,et s e&$lain this !ith some e&am$les# Mr# A b ys a Call on an inde& (s ch as ;ifty JI) !ith a strike $rice of Rs# 5III for $remi m of Rs# C3# Consider the val es of the inde& at e&$iration as 3CII, 3BII, 53II, and 55II# For + % / 3CII, *rofitF,oss / I D C3 / D C3 (ma&im m loss / $remi m $aid) For + % / 3BII, *rofitF,oss / I D C3 / D C3 (ma&im m loss / $remi m $aid) For + % / 53II, *rofitF,oss / 53II D 5III D C3 / 3B For + % / 55II, *rofitF,oss / 55II D 5III D C3 / 33B
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As !e can see from the e&am$le, the ma&im m loss s ffered by the b yer of the Call o$tion is Rs# C3, !hich is the $remi m that he $aid t o b y the o$tion# His ma&im m $rofits are nlimited and they de$end on !here the nderlyin" $rice moves# Puts An investor havin" a bearish o$inion on the nderlyin" can e&$ect to have $ositive ret rns by b yin" a $ t o$tion on that assetFsec rity# )hen a $ t o$tion is $ rchased, the $ t o$tion b yer has the ri"ht to sell the stock at the strike $rice on or before the e&$iry date de$endin" on !here the nderlyin" $rice is# Consider the $ rchase of a $ t o$tion at $rice ($remi m) 1# )e take + % / +$ot $rice a t time % 9 / e&ercise $rice %he $ayo t in t!o scenarios is as follo!s. *rofitF,oss / (9 D + % ) D $ if + % / 9 *rofitF,oss / D $ if + % / 9 ,et s e&$lain this !ith some e&am$les# Mr# T b ys a $ t at a strike $rice of Rs# 5III for a $remi m of Rs# LB# Consider the val es of the inde& at e&$iration at 3CII, 3BII, 53II, and 55II# For + % / 3CII, *rofitF,oss / 5III D 3CII D LB / 353 For + % / 3BII, *rofitF,oss / 5III D 3BII D LB / 53 For + % / 53II, *rofitF,oss / D LB (ma&im m loss is the $remi m $aid) For + % / 55II, *rofitF,oss / D LB (ma&im m loss is the $remi m $aid) As !e can see from the e&am$le, the ma&im m loss s ffered by the b yer of the * t o$tion is Rs# LB, !hich is the $remi m that he $aid to b y the o$tion# His ma&im m $rofits are nlimited and de$end o n !here the nderlyin" $rice moves#
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'hort o1tions strateg
A short o$tions strate"y is a strate"y !here o$tions are sold to make money $front !ith a vie! that the o$tions !ill e&$ire o t of money at the e&$iry date (i#e#, the b yer of the o$tion !ill not e&ercise the same and the seller can kee$ the $remi m)# As o$$osed to a lon" o$tions strate"y, here a $erson !ith a b llish o$inion on the nderlyin" !ill sell a $ t o$tion in the ho$e that $rices !ill rise and the b yer !ill not e&ercise the o$tion leadin" to $rofit for the seller# -n the other hand, a $erson !ith a bearish vie! on the nderlyin" !ill sell a call o$tion in the ho$e that $rices !ill fall and the b yer !ill not e&ercise the o$tion leadin" to $rofit for the seller# As o$$osed to a lon" o$tions strate"y !here the do!nside !as limited to the $rice $aid for the o$tion, here the do!nside is nlimited and the $rofit is limited to the $rice of sellin" the o$tion (the $remi m)# Calls An investor !ith a bearish o$inion on the nderlyin" can take advanta"e of fallin" stock $rices by sellin" a call o$tion on the assetFsec rity# If the stock $rice falls, the $rofit to the seller !ill be the $remi m earned by sellin" the o$tion# He !ill lose in case the stock $rice increases above the strike $rice# Consider the sellin" of a call o$tion at the $rice ($remi m) c# )e take + % / +$ot $rice at time % 9 / e&ercise $rice %he $ayo t in t!o scenarios is as follo!s. *rofitF,oss / c if + % / 9 *rofitF,oss / c D (+ % D 9) if + % / 9 ;o! consider this e&am$le. A sells a call at a strike $rice of Rs 5III for a $remi m of Rs C3# Consider val es of inde& at e&$iration at 3CII, 3BII, 53II, and 55II# For + % / 3CII, *rofitF,oss / C3 (ma&im m $rofit / $remi m received)
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For + % / 3BII, *rofitF,oss / C3 (ma&im m $rofit / $remi m received) For + % / 53II, *rofitF,oss / C3 D (53II D 5III) / D 3 B
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For + % /55II, *rofitF,oss / C3 D (53II D 55II) / D 33B
As !e can see from the e&am$le above, the ma&im m loss s ffered by the seller of the Call o$tion is nlimited (this is the reverse of the b yer4s "ains)# His ma&im m $rofits are limited to the $remi m received# Puts An investor !ith a b llish o$inion on the nderlyin" can take advanta"e of risin" $rices by sellin" a $ t o$tion on the assetFsec rity# If the stock $rice rises, the $rofit to the seller !ill be the $remi m earned by sellin" the o$tion# He !ill lose in case the stock $rice falls belo! the strike $rice# Consider the sale of a $ t o$tion at the $rice ($remi m) $ # )e take. + % / +$ot $rice at time % 9 / e&ercise $rice %he $ayo t in t!o scenarios is as follo!s. *rofitF,oss / $ D (9 D +%) if + % / 9 *rofitF,oss / $ if + % / 9 )e sell a $ t at a strike $rice of Rs# 5III for Rs# LB# Consider val es of inde& at e&$iration as 3CII, 3BII, 53II, and 55II# For + % / 3CII, *rofitF,oss / LB D (5III D 3CII) / (D ) 353 For + % / 3BII, *rofitF,oss / LB D (5III D 3BII) / (D ) 53 For + % / 53II, *rofitF,oss / LB (ma&im m $rofit / $remi m received) For + % / 55II, *rofitF,oss / LB (ma&im m $rofit / $remi m received)
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As !e can see from the e&am$le above the ma&im m loss s ffered by the seller of the * t o$tion is nlimited (this is the reverse of the b yer4s "ains)# His ma&im m $rofits are limited to the $remi m received# %etermination of o1tion 1rices ,ike in case of any traded "ood, the $rice of any o$tion is determined by the demand for and s $$ly of that o$tion# %his $rice has t!o com$onents. intrinsic val e and time val e# Intrinsic #alue and time #alue Intrinsic val e of an o$tion. Intrinsic val e of an o$tion at a "iven time is the amo nt the holder of the o$tion !ill "et if he e&ercises the o$tion at that time# In other !ords, the intrinsic val e of an o$tion is the amo nt the o$tion is in<the<money (I%M)# If the o$tion is o t <of< the<money (-%M), its intrinsic val e is (ero# * ttin" it another !ay, the intrinsic val e of a call is Ma& YI, (+ t Z 9)[ !hich means that the intrinsic val e of a call is the "reater of I or (+t Z 9)# +imilarly, the intrinsic val e of a $ t is Ma& YI, 9 Z + t[ i#e#, the "reater of I or (9 Z + t) !here 9 is the strike $rice and + t is the s$ot $rice# 3ime #alue of an o1tion In addition to the intrinsic val e, the seller char"es a \time val e4 from the b yers of the o$tion# %his is beca se the more time there is for the contract to e&$ire, the "reater the chance that the e&ercise of the contract !ill become more $rofitable for the b yer# %his is a risk for the seller and he seeks com$ensation for it by demandin" a \time val e4# %he time val e of an o$tion can be obtained by takin" the difference bet!een its $remi m and its intrinsic val e# Both calls and $ ts have time val e# An o$tion that is - t<of<the<money (-%M) or At<the<money (A%M) has only time val e and no intrinsic val e# Es ally, the ma&im m time val e e&ists !hen the o$tion is A%M# %he lon"er the time to e&$iration, the "reater is an o$tion4s time val e, all else bein" e2 al# At e&$iration, an o$tion has no time val e#
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Illustration In the follo!in" t!o tables, five different e&am$les are "iven for call o$tion and $ t o$tion res$ectively# As stated earlier, $remi m is determined by demand and s $$ly# %he e&am$les sho! ho! intrinsic val e and time val e vary de$endin" on nderlyin" $rice, strike $rice and $remi m# Intrinsic and %ime ?al e for Call -$tions. '&am$les
201213
Intrinsic and %ime ?al e for * t -$tions. '&am$les
Factors im1acting o1tion 1rices

%he s $$ly and demand of o$tions and hence their $rices are infl enced by the follo!in" factors. %he nderlyin" $rice, %he strike $rice,
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%he time to e&$iration, %he nderlyin" asset4s volatility,

201213
Risk free rate ,nderl ing +rices 'ach of the five $arameters has a different im$act on the o$tion $ricin" of a Call and a * t# %he
nderlyin" $rice. Call and * t o$tions react differently to the movement in the nderlyin" $rice# As the nderlyin" $rice increases, intrinsic val e of a call increases and val e of a $ t decreases# %h s, in the case of a Call o$tion, the hi"her the $rice of the nderlyin" asset from strike $rice, the hi"her is the val e ($remi m) of the call o$tion# -n the other hand, in case of a $ t o$tion, the hi"her the $rice of the nderlyin" asset, the lo!er is the val e of the $ t o$tion# 3he strike 1rice %he strike $rice is s$ecified in the o$tion contract and does not chan"e over time# %he hi"her the strike $rice, the smaller is the intrinsic val e of a call o$tion and the "reater is the intrinsic val e of a $ t o$tion# 'verythin" else remainin" constant, as the strike $rice increases, the val e of a call o$tion decreases and the val e of a $ t o$tion increases# +imilarly, as the strike $rice decreases, the $rice of the call o$tion increases !hile that of a $ t o$tion decreases# 3ime to e-1iration %ime to e&$iration is the time remainin" for the o$tion to e&$ire# -bvio sly, the time remainin" in an o$tion4s life moves constantly to!ards (ero# 'ven if the nderlyin" $rice is constant, the o$tion $rice !ill still chan"e since time red ces constantly and the time for !hich the risk is remainin" is red cin"# %he time val e of both call as !ell as $ t o$tion decreases to (ero (and hence, the $rice of the o$tion falls to its intrinsic val e) as the time to e&$iration a$$roaches (ero# As time $asses and a call o$tion a$$roaches mat rity, its val e declines, all other $arameters remainin" constant# +imilarly, the val e of a $ t o$tion also decreases as !e a$$roach mat rity# %his is called =time<decay>#
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8olatilit ?olatility is an im$ortant factor in the $rice of an o$tion# ?olatility is defined as the ncertainty of ret rns# %he more volatile the nderlyin" hi"her is the $rice of the o$tion on the nderlyin"# )hether !e are disc ssin" a call or a $ t, this relationshi$ remains the same#
Risk free rate Risk free rate of ret rn is the theoretical rate of ret rn of an investment !hich has no risk ((ero risk)# :overnment sec rities are considered to be risk free since their ret rn is ass red by the :overnment# Risk free rate is the amo nt of ret rn !hich an investor is " aranteed to "et over the life time of an o$tion !itho t takin" any risk# As !e increase the risk free rate the $rice of the call o$tion increases mar"inally !hereas the $rice of the $ t o$tion decreases mar"inally# It may ho!ever be noted that o$tion $rices do not chan"e m ch !ith chan"es in the risk free rate# %he im$act of all the $arameters !hich affect the $rice of an o$tion is "iven in the table belo!.
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'ven tho "h o$tion $rices are determined by market demand and s $$ly, there are vario s models of "ettin" a fair val e of the o$tions, the most $o$ lar of !hich is the Black +choles Merton Model# In this model, the theoretical val e of the o$tions is obtained by in$ ttin" into sin" this model are only indicative# form la val es of the above<mentioned five factors# It may be noted that the $rices arrived at by
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Real 41tions
An alternative or choice that becomes available !ith a b siness investment o$$ort nity# Real o$tions can incl de o$$ort nities to e&$and and cease $ro1ects if certain conditions arise, amon"st other o$tions# %hey are referred to as PrealP beca se they s ally $ertain to tan"ible assets s ch as ca$ital e2 i$ment, rather than financial instr ments# %akin" into acco nt real o$tions can "reatly affect the val ation of $otential investments# -ftentimes, ho!ever, val ation methods, s ch as ;*?, do not incl de the benefits that real o$tions $rovide# ;ote that this kind of o$tion is not a derivative instr ment, b t an act al o$tion (in the sense of PchoiceP) that a b siness may "ain by ndertakin" certain endeavors# For e&am$le, by investin" in a $artic lar $ro1ect, a com$any may have the real o$tion of e&$andin", do!nsi(in" or abandonin" other $ro1ects in the f t re# -ther e&am$les of real o$tions may be o$$ort nities for R]7, M]A and licensin"# Real -$tions ?al ation (R-?) is revol tioni(in" cor$orate strate"y and brid"in" the "a$ bet!een finance and strate"ic $lannin"# O st as an o$tion "ives its o!ner the ri"ht < b t not the obli"ation < to take a $artic lar co rse of action at some time in the f t re, fle&ibility embedded in ca$ital investment $ro1ects and com$any strate"ies allo!s mana"ers to take a sta"ed a$$roach to cor$orate strate"y and react to chan"es in the b siness environment, so they can limit do!nside losses !hile f lly ca$itali(in" on $side $otential o$$ort nities# Real 41tions 9 'ome E-am1les G G G G G G %efer < Investin" no! eliminates the o$tion to defer (learnin") E-1and < An o$tion to defer $art of the scale of investment &ontract < %he fle&ibility to red ce the rate of o t$ t Abandon < +to$ investin", and li2 idate e&istin" assets 'taging < + bstit te a series of small investments for one lar"e '$itching < Re<de$loy reso rces or chan"e in$ ts
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3echni;ues for Reasoning 3hrough %ecision 3rees 3# Foc s on the most im$ortant decisions# 5# Reason for!ard to constr ct the tree# 6# %rack certainties and ncertainties at each decision $oint# K# Calc late back!ard to eval ate choices# J# +elect the tree branch !ith the hi"hest e&$ected val e#
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%ecision 3ree E-am1le < Assum1tions Consider an investment $ro1ect !here there is ncertainty abo t the state of the !orld# + $$ose it can be either "ood or bad and it@s as likely to be one as the other# %he market research $rovides s the follo!in" data that. G G G G G G G G 7emand may be hi"h (6IM), medi m (JIM), lo! (5IM)# Cost of lar"e resta rant is HLJI,III# Cost of small resta rant is HNII,III# 'ntre$rene r !ill invest HKII,III, o tside investor $rovides the rest# Investor re2 ires 3M of e2 ity for each H3I,III invested# If demand is hi"h < *? lar"e is H3,JII,III, *? small is HCII,III# If demand is medi m < *? lar"e is HCII,III, *? small is HCII,III# If demand is lo! < *? lar"e is H6II,III, *? small is HKII,III#
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Acce1t2re=ect %ecision to In#est in Restaurant Business

201213
E#aluation of Acce1t2Re=ect Alternati#es G :arge9scale entr . / HJLJ,III / H35I,III / (H5IJ,III)
;*? conditional on hi"h demand ;*? conditional on intermediate demand ;*? conditional on lo! demand
;*? / #6 & HJLJ,III 0 #J & H35I,III D #5 & H5IJ,III / >(?(,@AA
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'mall9scale entr . / H5KI,III / H5KI,III / (H CI,III)

201213
;*? conditional on hi"h demand ;*? conditional on intermediate demand ;*? conditional on lo! demand
;*? / #6 & H5KI,III 0 #J & H5KI,III < #5 & HCI,III B >(CD,AAA G 7o not enter.
;*? / HI Restaurant Business In#estment $ith an 41tion to %ela In#esting
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E#aluation of 41tion to %ela G G ,ar"e<scale entry strate"y. ;*? / H3B3,JII 7elay ntil ncertainty is resolved. D Hi"h demand G G D B ild lar"e resta rant ;*? conditional on hi"h demand / HKKJ,III
Intermediate demand G G B ild small resta rant ;*? conditional on intermediate demand / H3NI,III
,o! demand G G 7o not enter ;*? conditional on lo! demand / HI
;*? of delay strate"y. D D / #6 & HKKJ,III 0 #J & H3NI,III 0 #5 & HI / H536,JII
?al e of -$tion to 7elay / H536,JII < 3B3,JII D / H55,III
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Restaurant Business In#estment $ith an 41tion to E-1and Initial In#estment
E#aluation of 41tion to E-1and G G G ,ar"e<scale entry strate"y. ;*? / H3B3,JII 7elay ntil ncertainty is resolved. ;*? / H536,JII B ild small, !ith -$tion to '&$and. D Conditional on Hi"h demand. G G G ;*? if '&$and / HJCI,III
;*? if Remain +mall / H5KI,III Concl sion. '&$and if demand is hi"h
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Conditional on Intermediate demand. G ;*? of Remainin" +mall / H5KI,III

201213
Conditional on ,o! demand. G ;*? of Remainin" +mall / (HCI,III)
;*? of +mall<scale entry !ith -$tion to '&$and D D / #6 & HJCI,III 0 #J & H5KI,III < #5 & HCI,III / H5LC,III G G D ?al e of '&$ansion -$tion / HCN,JII Incremental val e over 7elay -$tion / HNK,JII
%he -$tions are M t ally '&cl sive
E#aluation of 41tion to Abandon G G ,ar"e<scale entry strate"y. ;*? / H3B3,JII
,ar"e<scale entry !ith Abandonment o$tion. D D D Convert to office !ith HNII,III val e ;*? of convertin" for entre$rene r / (H3I,III) ;*? !ith Abandonment -$tion. G D / #6 & HJLJ,III 0 #J & H35I,III < #5 & H3I,III / H56I,JII
)o ld $ay $ to H6B,III e&tra for location that is convertible
+mall<scale entry !ith '&$ansion and Abandonment -$tions. D D D Convert to office !ith H6II,III val e ;*? of convertin" for entre$rene r / (H3NI,III) ;*? !ith Abandonment -$tion. G D / #6 & HJCI,III 0 #J & H5KI,III < #5 & H3NI,III / H5N5,III
Abandonment has ne"ative val e for the small resta rant

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D G
A res lt of discreteness of the analysis
Concl sion. B ild small !ith '&$ansion -$tion D ;*? / H5LC,III

201213
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8alue9at9Risk
201213
Histor of 8alue9at9Risk ?aR !as $ioneered by ma1or E#+# banks in the 4CIs, as the derivative markets develo$ed# %he birth of derivatives re$resented a ne! challen"e for risk mana"ement beca se traditional meas res of e&$os re !ere clearly inade2 ate# For e&am$le, t!o derivative contracts !ith the same notional val e co ld have very different risks# )ith ?aR, banks had develo$ed a "eneral meas re of economic loss that co ld e2 ate risk across $rod cts and a""re"ate risk on a $ort< folio basis# %he val e of a $ortfolio of financial assets is s b1ect to many risks. credit risks, market risks, etc# ?al e at Risk, ?aR, is a statistical estimate of the market risk of a $ortfolio# ?aR attem$ts to ans!er the follo!in" 2 estion# :iven a certain confidence level and a s$ecified time hori(on, !hat is the ma&im m $otential loss of the $ortfolioQ %efinition of 8aR %he val e at risk (?aR) indicates the ma&im m $ercenta"e val e of o r m lti$le tradin" systems $ortfolio that co ld be lost d rin" a fi&ed $eriod (e#"# one day) !ithin a certain confidence level (e#"# BJM)# ?aR is defined as the $redicted !orst<case loss at a s$ecific confidence level (e#"#, BJM) over a certain $eriod of time (e#"#, 3 day)# For e&am$le, every afternoon, O#*# Mor"an takes a sna$shot of its "lobal tradin" $ositions to estimate its 7aily<'arnin"s<at<Risk (7'aR), !hich is a ?aR meas re that Mor"an defines as the BJM confidence !orst<case loss over the ne&t 5K ho rs d e to adverse market movements# -ne the ma1or advanta"e of ?aR Method is that it !orks across different asset classes s ch as bonds and stocks# %he ele"ance of the ?aR sol tion is that it !orks on m lti$le levels, from the $osition<s$ecific micro level to the $ortfolio<based macro level# ?aR has become a common lan" a"e for comm nication abo t a""re"ate risk takin", both !ithin an or"ani(ation and o tside (e#"#, !ith analysts, re" lators, ratin" a"encies, and shareholders)# ?irt ally all ma1or financial instit tions have ado$ted ?aR as a cornerstone of day<to<day risk meas rement# ;o! !ith the ?aR method it is $ossible to meas re the a""re"ated risk on a $ortfolio level# B t there are some limitations of ?aR model that is it can only be achieved nder normal market condition# %hree a$$roaches for ?aR calc lation. Risk Metrics Historical sim lation
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Monte Carlo sim lation
Risk Metrics
201213
%he RiskMetrics variance model (also kno!n as e&$onential smoother) !as first established in 3BCB, !hen +ir 7ennis )eather stone4s, the ne! chairman of O#*# Mor"an, asked for a daily re$ort meas rin" and e&$lainin" the risks of his firm# ;early fo r years later in 3BB5, O#*# Mor"an la nched the RiskMetrics methodolo"y to the market$lace, makin" the s bstantive research and analysis that satisfied +ir 7ennis )eather stone4s re2 est freely available to all market $artici$ants# Risk metrics by definition is a set of financial models sed by investors to determine $ortfolio risk# Risk meas rement $rocess *ortfolio risk meas rement can be broken do!n into ste$s# %he first is modelin" the market that drives chan"es in the $ortfolio@s val e# %he market model m st be s fficiently s$ecified so that the $ortfolio can be reval ed sin" information from the market model# %he risk meas rements are then e&tracted from the $robability distrib tion of the chan"es in $ortfolio val e# %he chan"e in val e of the $ortfolio is ty$ically referred to by $ortfolio mana"ers as $rofit and loss, or *],# Market models RiskMetrics describes t!o models for modelin" the risk factors that define financial markets# Historical +im lation Monte Carlo sim lation
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Historical 'imulation H+ involves sin" $ast data as a " ide to !hat !ill ha$$en in the f t re + $$ose !e !ant to calc late ?aR for a $ortfolio sin" 3<day hori(on, a BBM confidence level, and JII days of data# Collect data on the daily movements in the "iven market variables#Cond ct JII trials ass min" as if todays $rices !ill chan"e at a $ast rate of chan"e in each of the JII days 0 %his !ay forecasted val e for tomorro! !ill be. v vn i vi 3
201213
)here ?n is today4s val e of the variable ?i is the variable val e in $ast days ?i<3 is the variable val e one<day before the vi val e After that, calc late the val e of $ortfolio based on the trial val es of each variable and find the difference bet!een the forecasted val es and today4s val e of the $ortfolio in all JII trials# Find the "iven $ercentile of these differences, and that !ill be the ?aR estimate# %he 3st $ercentile in JII observations means the Jth !orst loss in all JII observations In '&cel, !e do this by. /$ercentile (ran"e, #I3) if it is for 3st $ercentile#
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Monte &arlo simulation Risk analysis is $art of every decision !e make# )e are constantly faced !ith ncertainty, ambi" ity, and variability# And even tho "h !e have n$recedented access to information, !e can4t acc rately $redict the f t re# Monte Carlo sim lation (also kno!n as the Monte Carlo Method) lets yo see all the $ossible o tcomes of yo r decisions and assess the im$act of risk, allo!in" for better decision makin" nder ncertainty# Monte Carlo sim lation f rnishes the decision<maker !ith a ran"e of $ossible o tcomes and the $robabilities they !ill occ r for any choice of action# It sho!s the e&treme $ossibilitiesZthe o tcomes of "oin" for o t of b siness and for the most conservative decisionZalon" !ith all $ossible conse2 ences for middle<of<the<road decisions# Monte Carlo sim lation is a com$ teri(ed mathematical techni2 e that allo!s $eo$le to acco nt for risk in 2 antitative analysis and decision makin"# Ho$ Monte &arlo simulation $orks. Monte Carlo sim lation $erforms risk analysis by b ildin" models of $ossible res lts by s bstit tin" a ran"e of val esZa $robability distrib tionZfor any factor that has inherent ncertainty# It then calc lates res lts over and over, each time sin" a different set of random val es from the $robability f nctions# 7e$endin" $on the n mber of ncertainties and the ran"es s$ecified for them, a Monte Carlo sim lation co ld involve tho sands or tens of tho sands of recalc lations before it is com$lete# Monte Carlo sim lation $rod ces distrib tions of $ossible o tcome val es# 7 rin" a Monte Carlo sim lation, val es are sam$led at random from the in$ t $robability distrib tions# 'ach set of sam$les is called iteration, and the res ltin" o tcome from that sam$le is recorded# Monte Carlo sim lation does this h ndreds or tho sands of times, and the res lt is a $robability distrib tion of $ossible o tcomes# In this !ay, Monte Carlo sim lation $rovides a m ch more com$rehensive vie! of !hat may ha$$en# It tells yo not only !hat co ld ha$$en, b t ho! likely it is to ha$$en# Ad#antages Monte Carlo sim lation $rovides a n mber of advanta"es over =sin"le<$oint estimate> analysis. *robabilistic Res lts# Res lts sho! not only !hat co ld ha$$en, b t ho! likely each o tcome is#
201213
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:ra$hical Res lts# Beca se of the data a Monte Carlo sim lation "enerates, it4s easy to create "ra$hs of different o tcomes and their chances of occ rrence# %his is im$ortant for comm nicatin" findin"s to other stakeholders#
201213
+ensitivity Analysis# )ith 1 st a fe! cases, deterministic analysis makes it diffic lt to see !hich variables im$act the o tcome the most# In Monte Carlo sim lation, it4s easy to see !hich in$ ts had the bi""est effect on bottom<line res lts# +cenario Analysis. In deterministic models, it4s very diffic lt to model different combinations of val es for different in$ ts to see the effects of tr ly different scenarios# Esin" Monte Carlo sim lation, analysts can see e&actly !hich in$ ts had !hich val es to"ether !hen certain o tcomes occ rred# %his is very sef l for $ rs in" f rther analysis#
!ho uses Monte &arlo simulation" Many com$anies se Monte Carlo sim lation as an im$ortant tool for decision<makin"# Here are some e&am$les# :eneral Motors, *rocter and :amble, and 'li ,illy se sim lation to estimate both the avera"e ret rn and the riskiness of ne! $rod cts# At :M, this information is sed by C'- Rick )a""oner to determine the $rod cts that come to market# :M ses sim lation for activities s ch as forecastin" net income for the cor$oration, $redictin" str ct ral costs and $ rchasin" costs, determinin" its s sce$tibility to different kinds of risk (s ch as interest rate chan"es and e&chan"e rate fl ct ations)# ,illy ses sim lation to determine the o$timal $lant ca$acity that sho ld be b ilt for each dr "# )all +treet firms se sim lation to $rice com$le& financial derivatives and determine the ?al e at RI+9 (?AR) of their investment $ortfolios# *rocter and :amble ses sim lation to model and o$timally hed"e forei"n e&chan"e risk# +ears ses sim lation to determine ho! many nits of each $rod ct line sho ld be ordered from s $$liers Z for e&am$le, ho! many $airs of 7ockers sho ld be ordered this year#
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Financial Risk Management Whether we like it or not, mankind now has a completely integrated, international financial and informational

%o be alive at all involve some &isk

Khurasan Institute of Higher Education Jalalabad, Afghanistan.

MBA (Finance), CIA, CQC

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*B i / CII 0 53,JII < 5I,III

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