Page 193 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 3. Arbitrageurs also attempt to take advantage of price movements, but focus their efforts on
trying to profit from small discrepancies in price among similar instruments in different
markets.

Self Assessment

Fill in the blanks:
8. A …………… instrument is a financial contract whose value depends on the values of one
or more underlying assets or indexes.

9. Derivatives are used by banking organisations both as risk management tools and as a
source of ………………... .
10. ………………….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.
14.4 Types of Risks in Derivative Trading

Non-financial firms need to watch out for three main risks when using derivatives. The following
are the key risks associated with the derivative trading:

1. Market risk
2. Basic risk
3. Credit or Counterparty risk
The given below is the explanation of key risks:

1. Market risk: The possibility that the value of the derivative will change. This is essentially
no different from the risk involved in buying an equity or bond, or holding a currency–
except that the market risk may be magnified many times if the derivative is leveraged;
indeed some of the most famous disasters, including Procter & Gamble’s losses, were
associated with leveraged products. The other difference compared with equities, bonds
and so on is that the value of an option changes increasingly quickly as it becomes more
likely to be exercised.
2. Basic Risk: The derivative used may not be a perfect match with whatever it is intended to
hedge so that when the value of the underlying asset falls, the value of the derivative may
not rise by the expected amount.
3. Credit or “counterparty” risk: That the institution concerned will get into trouble and be
unable to pay up. Bear in mind, however, that the credit risk on buying a derivative is less
than that on, say, making a loan, as the cost of replacing a derivative contract is only the
amount to which the market has moved against the buyer since the original contract was
drawn up, whereas for the loan it is the entire amount lent. Derivatives bought from
banks are exposed to bigger credit risks than those bought from exchanges. This is because
exchanges guarantee contracts, and, unlike banks, ensure they can cover them by requiring
traders to stump up cash (“post-margin”) to cover potential losses in advance. However,
this increases the possibility that a firm might face liquidity problems.

188 LOVELY PROFESSIONAL UNIVERSITY