risk management

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Session 1
Risk Management
 Topics to be covered in this session:
 Futures and Forwards I

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Session Learning Objectives…
At the end of this session you should be able to :
 Explain the concept of derivatives
 Explain the forwards and futures contract
 State the concept of Hedge funds

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Derivatives
 Derivatives are instruments whose value is
derived from the value of one or more
underlying assets
 E.g.: Futures, forwards, swaps, options etc.
 The Underlying Assets can be:
 Stocks, currencies, interest rates,
commodities, credit risk of cash flows, etc.

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Trading Of Derivatives
 Exchanges such as the CBOE, NYMEX, NSE,
BSE, MCX, NCDEX
 Over-the-counter (OTC) market where traders
working for banks, fund managers and
corporate treasurers contact each other directly

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Uses of Derivatives
 To hedge the risks
 To speculate
 To lock in an arbitrage profit
 To change the nature of a liability

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 Lehman Brothers filed for bankruptcy on September
15, 2008 - the biggest bankruptcy in US history
 It was an active participant in the OTC derivatives
markets
 It got into financial difficulties as it took high risks
and found that it was unable to meet its short term
funding
 It had a large amount of transactions outstanding
with about 8,000 counterparties
 Unwinding these transactions became very difficult
for both the Lehman liquidators and their
counterparties
Lehman Brothers -Case

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An amount of $2,440.00 is deposited in a bank
paying an annual interest rate of 3.4%,
compounded continuously. Find the balance
after 2 years
Continuous Compounding

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Solution:
Continuous compound interest:
A = Pert,
Where, P = 2440, r = 3.4/100 = 0.034, t = 2, e =
2.7183 (approximately)
The balance after 2 years is approximately
$2611.69
Continuous Compounding

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 Hedge funds cannot offer their securities publicly
and are not subject to the same rules as mutual
funds.
 Mutual funds must
 Disclose investment policies
 Makes shares redeemable at any time
 Limit use of leverage
 Take no short positions
Hedge Funds

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 Hedge funds are not subject to the constraints
mentioned previously for the mutual funds
 Hedge funds use complex trading strategies
Hedge Funds

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 It is a customized agreement to buy or sell an
asset at today’s determined price which will be
settled at a certain time in future
 These are traded in the over-the-counter market
mostly between two financial institutions or
between a financial institution and a client
 One of them holds a long position and the other
holds a short position
Forward Contracts

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 Forward contracts can be used to hedge foreign
currency risk
 Mostly large banks have both:
 Spot traders : They trade in foreign currency
for almost immediate delivery
 Forward traders: they trade for delivery at a
future time
Forward Contracts

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 It is an agreement between two parties to buy or
sell an asset for a certain price at a certain time in
future
 They are normally traded on the exchanges
 A wide rage of commodities and financial assets
form the underlying assets in the various
contracts
 Some of the commodities are pork bellies, live
cattle, sugar, wool, lumber, cooper, aluminum,
gold and tin
 Some of the financial assets include stock indices,
currencies, and treasury bonds
Futures Contracts

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Futures & Forwards Contracts Comparison
FUTURES CONTRACT FORWARD CONTRACT
Traded on Organized exchanges Traded OTC
Standardized contracts, more
liquid
Customized Contracts, less liquid
Requires margin payment No margin payment required
Follows daily settlement No daily settlement
No counterparty risk Counterparty risk exists
Final settlement: By delivery of
underlying asset or cash settled
Final settlement: Settled by
delivery
Exit prior to maturity: by
offsetting the initial position
Exit prior to maturity: not
possible unless both parties
agree

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Before We End…
Summing up what we have learned and are now able to
do:
 Explain the concept of derivatives
 Explain the forwards and futures contract
 State the concept of Hedge funds

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Crib Sheet
Derivative
A derivative is a security whose
value is derived from the value
of the underlying asset. Example
of such an instrument includes
future, forward etc and the
underlying assets are stocks,
currencies etc.
Uses of derivatives
Derivatives have evolved as an
instrument for hedging the risk
associated in buying, holding,
and selling of various kinds of
financial assets. This instrument
is also used to speculate, lock in
an arbitrage profit, and change
the nature of a liability.
Hedge fund
A hedge fund is constructed with a
pool of invested money administered
by a fund manager with an object
maximising returns and elimination of
risk. Unlike a mutual fund, the hedge
fund cannot offer their securities
publicly.

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Crib Sheet
Forward contract
A forward contract may be described as an agreement to
buy or sell an asset at a predetermined price and at a
specified future time. These are traded in the over-the-
counter market. One of the participants may hold a long
position and the other may hold a short position.
Future contract:
This kind of instrument is used for managing or
hedging the risk in commodity and financial market
due to price fluctuations in the market. The nature of
futures is similar to forward contract however, in
terms of features and modalities of operation they are
vastly different from each other. This instrument is
normally traded on the exchange.

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