Use of Derivatives in Risk Management

Use of Derivatives in Risk Management

In the current business environment, risk management has taken an integral role in the central stage of business activities. This has been due to increased uncertainty in the business and inherent risks arising from business activities. Companies and business people use various tools in management of uncertainties in the business environment and prevent the business from risk arising from these uncertainties. Derivatives have played an imperative role in management of these risks at the corporate level. This has been prompted by the increasing volatility of financial markets and the corporate need to diversify these risks. In the current competitive global business environment, risk management plays an imperative strategic management and achievement of a competitive advantage (Kolb & Overdahl, 2002). In the current developed global financial market, derivatives have played an essential role in management of risks. This has been through a speculation and hedging in management of risks by corporate. Various derivatives have been used in management of risk of such options, futures and forwards. These instruments have been essential in risk management, which includes controlling and reduction of effects of risk occurrence.

This paper seeks to identify various derivatives that are used in the financial market in management and controlling of risks by companies. An analysis will be done on how each of derivatives identified in this paper is used in management of risk. There are various benefits accruing from the employment of derivatives in risk management, and they will be of much interest in this paper.

Analysis of Derivatives

Financial risks in financial markets arise from price fluctuations, which affect the value of products. These may be affected by fluctuation in the interest, deregulation of the international financial market, stiff global competition volatility of foreign exchanges. This has raised corporate concerns on profitability and uncertainty of future events that may affect the profitability of an organization. Therefore, management of risks in the current competitive business environment has become a key factor in business management and achievement of a competitive advantage. Derivatives are financial instruments whose value is deduced from the value of an underlying asset. These include futures, forwards and options, which may be traded over the counter or through exchanges. Derivatives are traded often as speculative instruments in the reduction of risk that may accrue from business (Johnson, 2007).

A future contract in management of risk includes an agreement between two parties who agree to buy or sell an underlying asset at specific future date and at a specific price. This was firstly practiced by rice farmers in the USA who used future contracts to avert the possibility of price fluctuations in the peak of rice production. In this contract, an investor will make an agreement with the farmer to sell, for example, a sack of rice at $150 at a specific future date. At the maturity of this date, the contract must be honored at the price set at the making of the contract. The contract is binding, and whether the price of rice will be $500 the price of the contract will be binding to the farmer and the investor. However, if the price of a sack of rice falls to $100 or $50, the investor will be under the obligation purchase the rice from the farmer at the set price of $150. This was used by farmers to guard their profits, due to various volatility in the market; farmers were assured their price could sell at a specific price (Brooks, 2000). Futures contracts have been essential in reducing the volatility of the financial market. The investor will face various inherent risks, as he will be speculating the future price of the rice, which may fall or rise depending on economic conditions and the season of productivity. Futures contracts are traded in the secondary market. The investor who holds the contract is bound to deliver the underlying asset at the specific price and on the agreed date. Futures contracts are standardized and can be transferrable from one person to the other. These contracts require delivery of the commodity in agreement when the contract matures at a specific future date. Under the futures contract, both parties are under the requirement to meet specific terms of the contract. These include the delivery of the commodity in the contract and payment of the agreed price by the investor at the specified future date. Futures contracts represent a symmetrical risk, since any party may gain or lose in an equal extent, such that what one person loses is the gain of the other party. Therefore, futures contract represents a zero sum game where the loss to a party is a loss to the other party.

Futures contracts are used by hedger in for controlling effects arising from volatility of prices in the market. Hedging  futures contracts involves taking a direct opposite position of the position held in the financial market (Kolb & Overdahl, 2002). It may involve buying, referred to as (a long) or selling referred to as (a short). In a short, the firm holds a cash position after which it sells the futures contract to avert risks that may arise from volatility of the price. A long is an anticipatory hedge, where the firm may hold a cash position and buys a future contract speculating an upward change in prices.  There are situations referred to as cross hedge where the firm holds both short and long positions simultaneously, but at different prices.

Forwards contracts are cash market transactions, where the seller agrees to deliver a certain commodity at a future date. These contracts are privately agreed and are not standardized like the futures contract. In addition, both parties risk simultaneously since one party holds the risk of the other party. They are not traded in formal exchanges, since they are private agreements between parties (Brooks, 2000). There is no agreement on the value of the agreement when making the contract and the price of the contract depends on the price in the market when the contract matures.  Forward contracts are traded over the counter and terms of the contract can be customized to fit the buyer’s and the seller’s needs. It is difficult to reverse a forward contract, since both parties must agree on refuting the contract. This increases credit risks faced by both parties and there are no overseeing agencies for contracts. Companies use derivatives in hedging for foreign currencies, where a change of the value of a currency may adversely affect the operation of the business. For example, a European company exports coffee to Canada and the value of the of the Canadian dollar falls against the euro. When the Canadian dollar per euro rate exchange increases, it will take more Canadian dollars to buy a euro meaning the Canadian dollar is depreciating. This would cause an increase in the sale of coffee and the company may not be affected adversely by foreign exchange changes. If the opposite happens, the sales of the company will be affected adversely. The company can use futures or forward contracts to minimize effects arising from changes on the foreign exchange (Kolb & Overdahl, 2002).

Options are derivative financial instruments; they represent a legally binding contract between two parties to sell or buy future underlying asset at a certain price referred to as the strike price over a given period. A call option gives the party the right but not a duty to buy the underlying asset at a certain price over a specified period. The option gives the person the right to call the option from another person. Under options, the buyer has the right but not a duty to fulfill obligations under the contract, while the seller is obliged to fulfill conditions under the contract. The difference between the strike price and the value of the option determines the price of the option (Johnson, 2007). In addition, there may be a premium, which will be based on the expiry period of the contract. Options are financial contracts where two parties enter into a contract and one party has the right to offer or receive a delivery of the underlying asset. However, the party is not obliged to offer the agreement of the contract where the other party is obliged to take or give the delivery of the contract. An option can be a call option where one party may take a short position in the underlying assets and buy the option. However, in a put option, the party holding the long position may sell the option to minimize the risk resulting from vulnerabilities due to the change in prices. The person holding the long position is the seller and is referred to as the writer, and the person holding the short position is the buyer referred to as the option buyer. The process of writing an option is referred to as the process of writing an option. An option can be an American or European option. In case of an American option, the buyer has the right to exercise the contract even before the maturity period. However, in the European option, the contract can only be exercised at the maturity of the contract (Rosen, 2000).

In a call option, the seller is under obligation to sell, while the buyer has the right to buy the implicit asset at a certain fixed price over a specified period. To illustrate this case, one can use the case of an auto insurance policy where the owner of a motor vehicle obtains an insurance cover against the accident. The owner of the motor vehicle expects that there will be no accidents during the period and the policy will end worthless. However, in case the accident happens, the owner approaches the insurance company for compensation and he is put back through a compensation of cash. The insurance claim provides a put option where the person will have the right to sell the option at the specific agreed price in the contract over the specified given period. In case of insurance companies, buyers have rights while sellers have obligations to fulfill the contract. Sellers have to buy rights under options to buy, while sellers are paid to fulfill obligations. In options, if the call buyer has the right to buy the underlying asset, the seller must have the obligation to sell the asset to the buyer. If a put buyer has the right to sell, then the seller will have an obligation to buy the option (Kolb & Overdahl, 2002).

Swaps are derivatives used in the financial market where two parties enter into a contract for the exchange of cash flows, which have identical maturity to take a comparative advantage, which will be accrued to either of the party or both parties. Swap can involve interest rates and currency swaps. Interest rate swap involves an exchange of the floating rate with a fixed rate between the two contracting parties. In currency swaps, contracting parties are enabled to exchange cash flows in two different currencies, while taking advantage of the interest rate differentials and exchange rate differentials. Swap contracts are notional in nature and contracting parties only exchange the interest rate differentials. However, swaps are liquidated at maturity and they are, therefore, illiquid before the maturity (Brooks, 2000).

Application of Derivatives

Derivatives are used in various business practices in diversification and the reduction of risk occurrences. They have widely been used in the financial market in speculating, hedging and arbitration of risk. For example, in the equity market and the volatility of market prices, investors hedge and speculate prices to make opportunities and reduce risks. In the primary financial market, there are various financial assets, which use derivatives in the risk management. For example, there are bonds, treasury bills, stocks deposits and currencies.  Derivative assets are assets whose value is dependent on the value of an implicit asset. They include futures, forwards, options and swaps (Sasidharan, 2009).

Futures have been used by farmers’ overtime to hedge risks due to volatility of the financial market and prices of the farm production in the market. These include wheat and rice futures, which guard and assure farmers of the price of their products when they harvest. Investors act as speculators who speculate prices, when the commodity is delivered on maturity of the contract. Futures contracts have been used in the modern financial market in speculation of changes in prices and interest rates. Investors and companies have made use of derivatives in the global financial market to reduce the impact of risk occurrence. Options have also been instrumental in risk management, for example, in the insurance industry. The policyholder has the right over the insurance policy while the insurance provider has the obligation to attend to the policyholder.

Fluctuating global oil prices have created uncertainty in global economies and companies have sought derivatives to prevent adverse effects on their operations. Therefore, companies have applied the use of derivatives in management of risks arising from fluctuating oil prices. Energy plays a vital role in production and companies employ all means to ensure the efficiency in supply of this factor of production.

Conclusion

In conclusion, risk management in current competitive global economies plays an essential role in business management. Firms aiming at achieving a competitive advantage need to realize the importance of the risk management. Current economic conditions in the globe have been changing and this has led to uncertainty in the business environment. This has led to use of derivative in the global financial market in hedging, speculation and arbitration. Various instruments have been used, such as the futures, forwards, options and swaps. Futures and forwards are used by farmers in hedging their risks due to volatility of prices in the market. Investors use futures in speculating prices of such futures and the gain of either party is the loss of the other party, they form a zero sum game. Options have been essential in speculation and arbitraging in financial markets and provision of insurance policies. Swaps have been used in currency and interest swaps where parties can gain benefits from interest differentials through the use of fixed and floating interests.