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Types of risk
Interest rate risk Interest rate risk is the risk of an adverse effect of interest rate movements on a firms profit. Exchange Risk Volatility in the exchange rates will have a direct impact on the values of assets and liabilities, which are denominated in foreign currencies. Default Risk(Credit Risk) Default risk is the risk of non recovery of sums due from outsiders. This risk has to be considered when credit is extended to any party.
Types of risk
Liquidity risk
Liquidity risk refers to the risk of a possible bankruptcy arising due to the inability of the firm to meet its financial obligations. A firm may be having huge profits but may have a severe liquidity crunch because it has blocked its money in illiquid assets.
Types of risk
Market Risk Market risk is the risk of the value of a firms investments going down as a result of market movements. Market risk cant be separated from other risks, as it results from presence of other risks. Interest rate risk and exchange rate risk contribute the most to the presence of market risk.
Types of risk
Types of risk
Financial risk Financial risk refers to the risk of bankruptcy arising from the possibility of a firm not being to repay its debts on time. Higher the debt-equity ratio of a firm, higher the financial risk faced by a firm.
Types of risk
Types of risk
Operational control risk Key personnel risk Frauds committed by staff electronic transactions risk.
Specify whether it would be more beneficial for a subsidiary to manage its own risk or to shift it to the parent company.
Specify whether the company would try to make profits out of risk management ( from active trading in derivatives market ) or stick to cover existing risks.
Cost of Risks
Risk identifying costs Costs which an enterprise incurs to identify and analyse the risks, like consultant fee. Risk Handling costs Certain expenses of handling risks, like insurance premium, loss prevention devices.
Cost of Risks
Social costs Costs that an enterprise may have to incur to compensate the society for damages caused by its actions. Ex: Union carbide had to pay millions of dollars as compensation to the victims of Bhopal Gas tragedy
Forward contracts
Forward contracts are the oldest and simplest form of derivative contracts. A forward contract is an agreement between two persons for the purchase and sale of a commodity or financial asset at a specified price to be delivered at a specified future date
Futures contracts
A futures contract is an agreement between a buyer and a seller that requires delivery of a specified quantity of a security, commodity or forex at a fixed time in the future at a price agreed to at the time of entering into the contract.
Individual stocks and stock index derivatives have a maturity date of the last Thursday of the contract month. If the last Thursday happens to be a holiday, the previous day will be the maturity day.
Every futures contract represents a specific quantity known as Lot size.
Remains fixed till maturity Changes everyday Not done Marked to market daily
Margin
Counter party risk
No margin is required
Present
No. of contracts in a year Any no. of contracts Hedging Liquidity Tailor made for specific dates & quantity. No liquidity
Mode of delivery
OPTIONS: INTRODUCTION
Option is one of the variants of derivative contracts Option contracts give its holder the right, but not the obligation, to buy or sell the specified quantity of the underlying asset for a certain agreed price (exercise/strike price) on or before some specified future date (expiration date). Call option gives its holder the right to buy. Put option gives its holder the right to sell.
1) Hedgers
Hedgers are attracted to derivatives market to reduce a risk that they already face. In the commodity market, hedging may be done by a producer or a miller or a stockist of goods.
2) Speculators
Speculators have a view on the future price of a commodity, shares, stock index, interest rates or currency. In contrast to hedgers who want to reduce their risk, speculators take a position in the market. Speculators provide hedgers an opportunity to manage their risk by assuming their risk.
3) Arbitrageur
An arbitrageur is risk averse and enters into those contracts where he can earn riskless profits. In imperfect markets, it is possible to make risk less profits by buying at a lower price in one market and selling at a higher price in another market or vice versa. Eg: Spot price of HDFC Bank is Rs.1000/- and its 3-month futures are at Rs.1040/-. Cost of carry (C) = F S * 365 * 100 S Days to maturity
6) Clearing house
The National Securities Clearing Corporation Ltd( NSCCL) is the clearing and settlement agency for all deals executed on NSEs F&O segment.