Page 192 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 14: Management of Derivatives Exposure

7. Risk Vision supports accurate …………. of numerous trade types, accurate exposure Notes
measurement and risk management measures like Value at Risk and Economic Capital.

14.3 Reasons for Managing Derivatives Risk

Objective of risk management is to lessen the effect of various kinds of threats to a certain level
which is accepted by the society. The various kinds of threat include threats caused by the
environment, threat caused by technology and also threat caused by the human beings. Various
kinds of threat also include threats caused by different organizations and also by politics. Risk
management can be accomplished by the skillful maneuvering of different kinds of resources
available for risk management like person, staff and also the organization.
In an ideal model of risk management, first of all the risk which may do the highest loss or has
got the highest probability to happen is first identified. The risks which have got more power to
do harm or have the more chance to occur are handled first and after that the risks which have
got less power to do harm and have got less chance to occur are handled.
This process of risk management may be very difficult in the actual field. A proper balance
between the risks which have got more possibility to happen and the risks which have got less
possibility to happen is very difficult to make. Handling of different types of risks among a
basket of risks may become very difficult to the risk management group engaged in risk
management but there is no other way to handle the risks properly.
Derivatives instruments have become increasingly important to the overall risk profile and
profitability of banking organisations throughout the world. Broadly defined, a derivatives
instrument is a financial contract whose value depends on the values of one or more underlying
assets or indexes.

Did u know? What is the scope of derivative products?
Derivatives transactions include a wide assortment of financial contracts, including
forwards, futures, swaps and options.

In addition, other traded instruments incorporate derivatives characteristics, such as those with
imbedded options. While some derivatives instruments may have very complex structures, all
of them can be divided into the basic building blocks of options, forward contracts or some
combination thereof. The use of these basic building blocks in structuring derivatives instruments
allows the transfer of various financial risks to parties who are more willing or better suited, to
take or manage them.
Derivatives are used by banking organisations both as risk management tools and as a source of
revenue. From a risk management perspective, they allow financial institutions and other
participants to identify, isolate and manage separately the market risks in financial instruments
and commodities. When used prudently, derivatives can offer managers efficient and effective
methods for reducing certain risks through hedging. Derivatives may also be used to reduce
financing costs and to increase the yield of certain assets. For a growing number of banking
organisations, derivatives activities are becoming a direct source of revenue through “market-
making” functions, position taking and risk arbitrage:
1. “Market-making” functions involve entering into derivatives transactions with customers
and with other market-makers while maintaining a generally balanced portfolio with the
expectation of earning fees generated by a bid/offer spread
2. Position-taking, on the other hand, represents efforts to profit by accepting the risk that
stems from taking outright positions in anticipation of price movements

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