RISK MANAGEMENT MODULE F QUIZ 1

A derivative derives its value from an underlying asset, rate, index or other variable. Derivatives may be used to hedge exposures, take positions or facilitate risk transfer. They can also create leverage and require careful control.

OTC derivatives are negotiated between counterparties and can be tailored to their needs, but may involve greater bilateral counterparty, valuation and liquidity risk. Exchange-traded derivatives are standardised and typically cleared through a central counterparty, subject to exchange and clearing rules.

An importer with a future dollar payable is exposed to a rise in the dollar/rupee rate. Buying dollars forward or using an appropriate long-dollar derivative position can lock in or offset the exchange-rate risk. The hedge should match amount, date and exposure as closely as practicable.

Derivatives can be misused when positions are taken without understanding exposures, limits, valuation, collateral needs or potential losses. A derivative should not be treated as inherently safe simply because it requires a relatively small initial cash outlay.

The long forward payoff at maturity is spot price minus the contracted forward price, S_T − K. Here, ₹112 − ₹100 = ₹12 per unit. This is the payoff at maturity, not necessarily the contract’s value before maturity.

The short forward payoff at maturity is the contracted forward price minus the maturity spot price, K − S_T. Here, ₹250 − ₹230 = ₹20 per unit. The short benefits when the market price at maturity is below the contracted selling price.

The forward price is the delivery price agreed for a new contract initiated at current market conditions. The value of an existing contract is the current economic worth of its remaining contractual cash flows; it may be positive, negative or approximately zero at inception under fair-market terms.

Forwards are often customised and may match an exposure closely, but they generally have less standardisation and may be harder to exit. They also expose parties to bilateral counterparty risk unless mitigated through collateral, netting or other arrangements.

For an asset with no income or storage costs, the no-arbitrage forward price under continuous compounding is F₀ = S₀e^(rT), where S₀ is spot price, r is the risk-free rate and T is time to maturity. Income and carrying costs modify the relationship.

Known income earned by the holder of the underlying reduces the net cost of carrying the asset. In a simplified continuous-compounding model with known income yield q, F₀ = S₀e^((r−q)T), so a positive income yield lowers the theoretical forward price compared with no income.

A borrower who will pay a floating interest rate fears a rise in rates. A long FRA position is commonly used to hedge that increase: under standard market conventions, the FRA settlement offsets the higher interest cost when the reference rate rises. Exact payer/receiver terminology should be checked against the contract convention.

Futures are standardised contracts traded on an exchange, with clearing arrangements, margin requirements and daily mark-to-market. Forwards are usually bilateral and customisable, with settlement and collateral terms agreed between counterparties.

A central counterparty interposes itself between clearing members and manages counterparty exposure through margin, default-fund arrangements and default-management procedures. It reduces bilateral exposure complexity but does not eliminate all systemic, liquidity or operational risks.

Initial margin is collateral intended to cover potential future exposure over a close-out period. Variation margin settles gains and losses from mark-to-market movements, helping keep the clearing exposure current. Specific margin rules depend on the exchange and clearing house.

For a properly functioning deliverable futures market, futures and spot prices generally converge as expiry approaches because delivery or cash-and-carry arbitrage links them. Differences can persist due to frictions, restrictions or settlement design, but a large unexplained gap invites arbitrage pressure.

Contango describes a futures curve in which longer-dated futures prices are above nearer-dated prices, often because financing, storage and other carrying costs exceed benefits of holding the commodity. The term describes curve shape and does not alone guarantee a profit.

In the classical theory, normal backwardation occurs when the futures price is below the expected future spot price, reflecting a risk premium paid to induce speculators to take the other side of hedgers’ positions. It is distinct from simply observing an upward or downward futures curve today.

A call is in the money when the underlying price exceeds the strike. Its intrinsic value here is ₹540 − ₹500 = ₹40 per share, ignoring premium and contract multiplier. The option holder is not obliged to exercise if doing so is disadvantageous.

A put’s intrinsic payoff at expiry is max(K − S_T, 0). Here, ₹200 − ₹170 = ₹30 per unit. The buyer’s net profit would also account for the premium paid.

The buyer pays a premium for the right, but not the obligation, to buy the underlying at the strike. If the option expires worthless, the buyer’s loss is generally limited to the premium paid, excluding fees and other transaction costs. The seller may face much larger exposure depending on the position.