Page 12 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 1: Introduction to Derivatives

impact the revenues and cost of our firm. An oil refiner might find himself paying more for Notes
crude oil, or a jewelry manufacturer more for gold. Such movements may adversely affect his or
her business, and even threaten its viability. Derivatives, usually in the form of options and
futures are, therefore, used as means to protect against key business risks which are beyond
one's control. Systemic risks are part and parcel of being in business, and it is for accepting such
risks that the market rewards us with a return. We can expect that when a firm's performance
varies systematically with those of firms in the industry, (a high positive beta), options and
futures may be used to enhance its value by managing such risks. They are, therefore, of use to
anyone wishing to reduce or limit the impact with which such risks may have. The need to
manage external risk is the primary reason for the existence of futures and options. Now, parties
wishing to manage their risks are known as hedgers. The importance of derivatives is primarily
for hedging risk exposure as used by hedgers.
The derivatives market performs a number of economic functions:

1. Discovery of Prices: Prices in an organized derivatives market reflect the perception of
market participants about the future and lead the prices of underlying to the perceived
future level. The prices of derivatives converge with the prices of the underlying at the
expiration of the derivative contract. Thus derivatives help in discovery of future as well
as current prices.
2. Transfer of Risk: The derivatives market helps to transfer risks from those who have them
but may not like them to those who have an appetite for them. i.e., from Hedgers to
Speculators.
3. Liquidity and Volume Trading: Third, derivatives, due to their inherent nature, are linked
to the underlying cash markets. With the introduction of derivatives, the underlying
market witnesses higher trading volumes because of participation by more players who
would not otherwise participate for lack of an arrangement to transfer risk.
4. Trading Catalyst: An important incidental benefit that flows from derivatives trading is
that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of
attracting many bright, creative, well-educated people with an entrepreneurial attitude.
They often energize others to create new businesses, new products and new employment
opportunities, the benefits of which are immense.

Self Assessment

State the following are true or false:
11. Rates of return are meaningful only in the context of how probable it is to achieve.

12. The importance of derivatives is primarily for hedging risk exposure as used by hedgers.
13. Derivatives are used to discover the future price only.

1.4 Exchange Traded vs. OTC Derivatives

Derivatives that trade on an exchange are called exchange traded derivatives, whereas privately
negotiated derivative contracts are called OTC contracts. The OTC derivatives markets have
witnessed rather sharp growth over the last few years, which have accompanied the
modernization of commercial and investment banking and globalization of financial activities.
The recent developments in information technology have contributed to a great extent to these
developments. While both exchange-traded and OTC derivative contracts offer many benefits,
the former have rigid structures compared to the latter. It has been widely discussed that the

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