Derivatives And Risk ManagementAssignment 1

Fundamentals Of Future and Forward Contracts

A derivatives is a financial instrument which derive their value from the value of underlying asset, Reference Rate or Index Rate. The followings are major financial derivative products. Forward Contracts Future Contracts Options SwapsWe will start with the concept of Forward contract and then move on to understand Future contracts.Forward ContractsA Forward is a customized contract between two parties where one commits to buy and other commits to sell a specified quantity of an agreed upon asset for a pre-decided cost at a particular date in the future. It is also known as Private Contracts which is traded outside exchange. Forward Contract Example:FarmerBread MakerI agree to sell 500kgs wheat at Rs.40/kg after 3 months.

3 Months Later

500 Kgs wheatBread Maker

Farmer

Rs. 20,000

Risks In Forward Contracts Credit Risk : Does the other party have the intends to pay? Operational Risk : Will other party make or accept delivery ? Liquidity Risk : How to find other counter entity if either wants to opt out of the contract.Terminology Buyers hold Long Position Seller hold Short Position Spot Price : Price of the asset in the current market Delivery or Forward PriceFuture ContractsThough, Forward Markets have proved very functional for hedging and investments purposes but still has various drawbacks. As we can say, Forward Markets are not exchange traded and there can be problems with price transparency and liquidity and also there is a counter party risk. In future markets, these problems have been largely eliminated. It is standardized forward contracts and traded on organized exchange.Future Contracts ExampleProfit $2Profit $4

Profit $2

S $14S $12S $14S $10CMarket Price/Spot PriceD1 $10D2 $12D3 $14S $12L $10BA

Types Of Future Contracts Stock Future Trading which deals with shares Commodity Future Trading which deals with gold and crude oil features Index Future Trading which deals with Stock Market indicesClosing A Future Position In the event that held till expiry, they are for the most part settled by conveyance. (2-3%) Most Future contracts are not held till expiry, but rather shut before that. By shutting a Future contract before expiry, the net contrast is settled between merchants, without physical conveyance of the hidden.Terminology Contract Size: The measure of the benefit that must be conveyed under one agreement. All fates are sold in products of parts which is chosen by the trade board. Eg. On the off chance that the parcel size of Tata steel is 500 shares, then one fates contract is essentially 500 shares. Contract Cycle Expiry Date: typically last Thursday of each month or earlier day if Thursday is public holiday

Risk ManagementRisk Management includes recognizing, examining, and making moves to diminish or dispose of the exposures to misfortune confronted by an association or person. The act of danger administration uses numerous devices and methods, including protection, to deal with a wide assortment of dangers. Each business experiences chances, some of which are unsurprising and under administration's control, and others which are unusual and wild.The objective of Risk Management include: Guiding arranging and control exercises, staying away from hierarchical and practical covers; serving to build up a partners focused association; Reimbursing of starting speculations by maintaining a strategic distance from expense overwhelm, boosting open doors and obliging disappointments; The likelihood to utilize an incremental, regulated methodology for its improvement and usage.Steps involved in Risk Management ProcessRisk Management Process is characterized as the methodical use of administration strategies, methodology and practices embraced to the assignments of setting up the connection, distinguishing, examining, evaluating, treating, checking and imparting dangers.

Example of Risk Management for a Travel AgencyThis sample hazard appraisal demonstrates the sort of methodology a little business may take. It can be utilized as a manual for thoroughly consider a percentage of the dangers in your business and the strides you have to go out on a limb. It would be ideal if you take note of that it is not a nonspecific danger evaluation that you can simply put your organization name on and receive wholesale with no idea. This would not fulfill the law - and would not be powerful in ensuring individuals. Each business is diverse - you have to thoroughly consider the risks and controls needed in your business for yourself.There are three types of Traders in Derivatives Market HedgerA hedger is somebody who confronts danger connected with value development of a benefit and who utilizes subsidiaries as method for decreasing danger. They give monetary offset to the business sector SpeculatorA dealer who enters the fates market for quest for benefits, tolerating hazard in the attempt. They give liquidity and profundity to the business. ArbitrageurA man who at the same time goes into exchanges in two or more markets to exploit the errors between costs in these business sectors. Arbitrage includes making benefits from relative mispricing. Arbitrageurs additionally help to make markets fluid, guarantee exact and uniform estimating, and upgrade value soundness They help in achieving value consistency and disclosure.