Risk in Investing in Derivatives

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FINANCIAL DERIVATIVES

“Risk in Investing in Derivatives”

Submitted By:
Zeeshan Saeed (9961)
Hashim Mamsa (10138)
Fawaz Shaikh (11276)
Ali Kazi (10537)
Submitted To:
Mrs. Shazia Farooq

TABLE OF CONTENTS
INTRODUCTION_______________________________________________________________________3
Types of Risk:_________________________________________________________________________4
I. Market Risk:………………………………………………………………………………………………………………………………………….4
II. Default risk………………………………………………………………………………………………………………………………………….5
III. Liquidity Risk:………………………………………………………………………………………………………………………………………5
IV. Operational Risk………………………………………………………………………………………………………………………………….5
V. Legal Risk:…………………………………………………………………………………………………………………………………………….5 VI. Agency Risk:……………………………………………………………………………………………………………………………………….…6 VII. Systemic Risk:……………………………………………………………………………………………………………………………………….6

ADVANTAGES OF RISK_________________________________________________________________7
1.Facilitates Transfer of Risk:…………………………………………………………………………………………………………..7
2.Enable Price Discovery:’………………………………………………………………………………………………………………..7
3.Provide Leveraging:…………………………………………………………………………………………………………………….7
4.They Improve Market Efficiency for the Underlying Asset…………………………………………………………….7
5.Derivatives Also Help Reduce Market Transaction Costs……………………………………………………………..7
DISADVANTAGES OF RISK______________________________________________________________8
1. Time decay………………………………………………………………………………………………………………………………………8
2. Raises Volatility:……………………………………………………………………………………………………………………………8
3. Higher no. of Bankruptcies:……………………………………………………………………………………………………………8
4. Company Reputation:……………………………………………………………………………………………………………………..9
5. Restrict the innovation:…………………………………………………………………………………………………………………9
BACKGROUND OF THE RESEARCH AND SIMILAR CASES______________________________________9
CASE 1_____________________________________________________________________________9
CASE 2_____________________________________________________________________________13
CASE 3_____________________________________________________________________________17
CONCLUSION________________________________________________________________________19

INTRODUCTION

Derivative security markets have shown extraordinary growth over the past the past two decades. But certain events have raised concern about the risks associated with derivatives trading. Over the past two decades, the financial markets have experienced an impressive expansion in terms of securities issued and traded on the secondary markets. In addition, financial markets have become more and more interconnected allowing almost continuous trading in some precious metals, currencies and stocks traded on several exchanges. The securitization process of traditional banking activities - such as the mortgage backed securities appearance -determined one way to expand the risk sharing possibilities of market participants. Financial innovation that led to the issuance and trading of derivative products has been another perhaps even more important boost to the changes and development of financial markets. Derivative products such as options, futures or swap contracts have become a standard risk management tool that enables risk sharing and thus facilitates the efficient allocation of capital to productive investment opportunities. Moreover, derivative instruments contribute to complete the financial markets and to gather information that is not readily available from trading in the physical markets. While the benefits stemming from the economic functions performed by derivative securities have been discussed and proven by academics, there is increasing concern within the financial community that the growth of the derivatives markets - whether standardized or not - destabilizes the economy. In particular, one often hears that the widespread use of derivatives...
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