Risk Management: Basics

of Financial Engineering
BITS Pilani Dr. Saurabh Chadha
Pilani Campus
Financial Risk
Financial Price Volatility
• Interest Rates
• Exchange Rates
• Commodity Prices
Therefore, the risk that the price of something will change
significantly such that it results in a loss.

For example, if one has an investment in a foreign currency

and that currency changes in value, it may adversely affect the
investment's value.

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Risk Profile
• The increase in the volatility of prices and rates may or may not
be a matter of concern to a firm.
• It depends upon the nature of its operations and financing.
Example: Exchange rate fluctuations are a great concern for a
mainly export-oriented company but are of much less concern to a
firm with little or no international activity.
• Risk profile is a basic tool for measuring a firm’s exposure to
financial risk.
• It is a graph showing the relationship between changes in the
prices of some good or service and changes in the value of the
firm.

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Risk profile for an oil producer

• It is a relationship between changes in the value of the firm (ΔV)

and unanticipated changes in oil prices (ΔPoil).
• There is a positive relationship (upwards sloping) i.e. the value of
the firm increases when oil price increases.
• Also, the slope is fairly steep, implying the firm has a significant
exposure to oil price fluctuation.
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Managing Financial Risk
• A derivative is a contract between two or more parties whose
value is based on an agreed-upon underlying financial asset (like
a security) or set of assets (like an index). Common underlying
instruments include bonds, commodities, currencies, interest
rates, stocks etc. Common derivatives are:
• Forward contracts
• Futures contracts
• SWAP contracts
• Option contracts

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Forward Contracts
• A forward contract represents an agreement between two parties to
exchange an asset for cash at a predetermined future date (settlement
date) for a price that is specified today.
Example: If you agree on January 1 to buy 100 bales of cotton on July 1
at a price of Rs 800 per bale from a cotton dealer, you have entered into a
forward contract with the cotton dealer.
• You have bought forward cotton or long position. Long position
which commits the buyer to purchase an item at the contracted price
on maturity.
• Cotton dealer has sold forward cotton or short position. Short
position which commits the seller to deliver an item at the contracted
price on maturity.
• No money or cotton changes hand when the deal is signed. A forward
contract only specifies the terms of a transaction that will occur in
future.

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Forward Contracts – The Payoff Profile

What are the payoffs to the forward buyer and forward seller?
• When the spot price (P) > contract price (C), the forward buyer’s gain is:
spot price – contract price.
• When the spot price (P) < contract price (C), the forward buyer’s loss is:
contract price – spot price.
• The payoff to the seller of a forward contract is the mirror image of the
payoff to the buyer.
• The gain of the buyer is the loss of the seller and vice versa.

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Hedging with Forward Contracts
Let us consider the case of a power company that uses oil as fuel.
• Assuming that the tariff this company can charge cannot be
adjusted quickly in the short run.
• Therefore, a sudden change in the price of oil is a source of risk.
• Risk profile for an oil buyer is

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Hedging with Forward Contracts

What should this company do to cope with its oil risk?

• It should buy a forward contract.
• The forward contract reduces the power company’s net exposure
to oil price fluctuations to zero.
• If the oil prices rises, the damage from the higher price is offset
by the gains on the forward contract and vice versa.
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Forward Contracts - Conclusion

• Thus, forward contract protects against the risk of an

adverse price change, but it also eliminates the potential
gain from a favorable price change.
• At the time a forward contract is initiated, no money
changes hand. There is no upfront cost.
• However, since a forward contract involves future
obligations, it carries a credit risk.
• On the settlement date, the party on the losing side of the
contract has an incentive to renege on the agreement.

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Futures Contracts

• A futures contract is a standardized forward contract. The

key differences between forwards and futures are as follows:
Forward Contracts Futures Contracts

• Tailor-made contract i.e. the • Standardized contract i.e. quantity,

terms are negotiated between the date and delivery conditions are
buyer and seller. standardized.
• No secondary market. • Traded on organized exchanges.

• End with deliveries. • Only cash settled.

• No collateral is required. • Margin is required.

• Settled on maturity date. • “Marking-to-Market” on a daily

basis i.e. profits and losses on
futures contracts are settled daily.

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Futures Contracts
• The “Marking-to-Market” feature of futures contract is the most
distinctive feature.
Example: Suppose on Monday morning you take a long position in
a futures contract that matures on Friday afternoon. The agreed
upon price is Rs 100. At the close of trading on Monday, the future
price rises to Rs 105. The marking-to-market feature means that
three things occur:
• First, you will receive a cash profit of Rs 5.
• Second, the existing futures contract with a price of Rs 100 is
cancelled.
• Third, you will receive a new futures contract at Rs 105.
Thus, the marking-to-market feature implies that the futures
contracts are settled every day.
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Futures Contracts and Exchanges
Broadly, there are two types of futures: Commodity futures and financial futures
• A commodity futures is a contract in commodity like aluminum, gold, coffee, sugar
etc.
• A financial futures is a contract in a financial instrument like treasury bill, currency,
stock etc.
Commodity Exchange Financial Futures Exchange
Futures
Aluminum MCX, NCDEX BSE Sensex BSE
Cashew NCDEX S&P CNX Nifty NSE
Gold MCX, NCDEX NSE Bond Futures NSE
Coffee NMCE, NCDEX USDINR NSE
Sugar MCX, NCDEX,
NMCE
MCX: Multi Commodity Exchange of India Ltd; NCDEX: National Commodity and
Derivatives Exchange Ltd; NMCE: National Multi Commodity Exchange of India Ltd;
BSE: Bombay Stock Exchange; NSE: National Stock Exchange
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Futures and Hedging
Example: Suppose a coffee plantation firm expects a harvest of
1000 tons of coffee three months from now. If the uncertainty
about the future price bothers it, it can sell a futures contract for
1000 tons. Such a simple hedge eliminates the risk of price
fluctuation.

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SWAP Contracts
• A SWAP contract is an agreement between the two parties to
exchange one set of cash flows for another.

• In essence, it is a portfolio of forward contracts. A forward

contract involves one exchange whereas a swap contract entails
multiple exchanges over a period of time.

Types of SWAP Contracts:

• Currency Swaps
• Interest Rate Swaps
• Commodity Swaps

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Currency Swaps
• In a currency swap, two parties agree to exchange a specific
amount of one currency with a specific amount of another at
certain dates in future.
Example:
Indian Railway Finance Corporation (IRFC) and Banks did a
currency swap.
• Under this swap, banks would pay USD 80 million to IRFC in 5
equal installments of USD 16 million each.
• In return, IRFC would pay banks the rupee equivalent in
installments at a predetermined conversion rate.
• IRFC needed USD 80 million to repay a Euro-currency loan.

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Interest Rate Swaps
• An interest rate swaps is a transaction involving an exchange of one
stream of interest obligations for another.
• It effectively translates a floating rate borrowing into a fixed rate
borrowing and vice versa. The net interest differential is paid or
received as the case may be.
• There is no exchange of principal repayment obligations.
• It is structured as a separate contract distinct from the underlying
loan agreement.
• It is applicable to new as well as existing borrowings.
• It is treated as an off-balance sheet item.
Interest rate and currency swaps may be combined. A company
may obtain floating rate interest in a particular currency and
swap with a fixed rate interest in another currency.

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Commodity Swaps and Swap Dealers
• A commodity swap is a contract to exchange a specified quantity of
a commodity at a specified price at fixed times in future.
Example: An oil user needs 100,000 barrels every quarter. It can
enter into a commodity swap contract with an oil producer to supply
the quantity it requires at a specified price over the next 2 years.
• Swap contracts are not standardized contracts i.e. they are not
traded on an organized exchange.
• Therefore, a firm interested in a swap agreement typically contacts
a swap dealer i.e. Commercial banks are the dominant swap
dealers to take the other side of the swap agreement.
• The swap dealer in turn will try to enter into an offsetting
transaction with some other party or dealer. Otherwise it may cover
its exposure using future contracts.
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Interest Rate Swap: An Example
Consider the following data:
Information Company P Company Q
Desired Funding Fixed Rate; $10 million Floating Rate; $10 million

Cost of Fixed Rate Funding 8% 8.75%

Cost of Floating Rate Funding LIBOR + 100bp LIBOR + 250bp

Both the companies have approached a swap banker for arranging a

swap in such a way that the savings is split equally among all the
three. Show diagrammatically how you will arrange such a swap.

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Interest Rate Swap: An Example

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Option Contracts
• An option contract is an agreement under which the seller (or
writer) of the option grants the buyer (or holder) the right, but not
the obligation, to buy or sell (depending on whether it is call option
or a put option) some asset at a predetermined price during a
specified period.
• Clearly, the buyer (or holder) of an option has to pay a premium to
the enjoy the right.
• In a forward contract both parties are obligated to transact in
future. In an option contract the transaction occurs only if the
buyer (or holder) of the option chooses to exercise it.
• No money changes hand in a forward contract. On the other hand,
the buyer of the option contract pays option premium to the seller
of the option.
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Option Payoffs Profiles
Payoff Profiles for Call option: The horizontal axis shows the
difference between the market value of the asset and the exercise price
of the option; the vertical axis shows the payoffs from the options.
Part A shows the payoff profile of a call option from the buyer’s point
of view and Part B from seller’s point of view. The seller’s payoff
profile is exactly the mirror image of the buyer’s.

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Option Payoffs Profiles
Payoff Profiles for Put option: Part C shows the payoff profile of a
put option from the buyer’s point of view and Part D from seller’s
point of view. The put option gives the right to sell an asset at the
exercise price. If market value of the asset falls below the strike price,
it is the buyer profits because the seller of the put option is obliged to
pay the exercise or strike price.

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Hedging with Options
Suppose a firm has a risk profile of the kind shown below. What should it do
if it wishes to use options to hedge against adverse price movements?

• Looking at the payoffs, it appears that buying a put option suit this firms.
• By buying a put option the firm eliminates the “downside” risk while
retaining the upside potential.
• The put option serves like an insurance policy. However, like any
insurance it costs money because the firm has to pay the option premium.

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Option Contracts - Conclusion
• Investors buy calls if they think the stock is going up in the future
or if they sold the stock short and want to hedge against a possible
surge in price.
• Investors buy puts if they think the stock is going down or if they
own the stock and want to hedge against a possible price decline.
• In general, the closer the stock price is to the exercise price, the
higher the option premium or price.
• The option premium is driven by its value, and as soon as the stock
hits the exercise price it becomes valuable.
• Options expire either in the money or out of the money.
• In-the-money options have triggered the exercise price and are
valuable, and out-of-the money options expire without triggering
the exercise price and are not valuable.

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