Use Of Derivatives In Risk Management

Running head: DERIVATIVES IN RISK MANAGEMENT 1

Use of Derivatives in Risk Management

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DERIVATIVES IN RISK MANAGEMENT 2

Introduction

Derivatives refer to instruments whose structural variables and characteristics are

established on the structural variables and characteristics, of other underlying instruments that

are basic. The variables and structural characteristics that are associated with derivatives include

the amount and timing of cash flows, and risks involving exchange rates. Prepayments,

valuation, credits and exposure to rates of interest are also included. On the other hand, the

instruments of derivatives include futures, forwards, options, swaps and caps amongst others.

Risk management refers to the establishment, analysis and prioritization of risks followed by a

coordinated application of resources (Ahlgrim, 2003). The resources are often applied in an

economical way in order to monitor, minimize and regulate the effects of events that are

unforeseen. In addition, this could also be done to maximize the achievement of opportunities.

Risks emanate from unpredictable project failures, financial markets, production and natural

disasters amongst others. The use of derivatives plays a crucial role the provision of adequate

mechanisms of managing risks that are associated with finances (Finch1997). The risks that

involve the application of derivatives include foreign exchange risks, interest rates risks and fair

value risks. In addition, the use of derivatives is also applicable in commodity input hedging.

Issues involved in the Use of Derivatives in Risk Management

Several issues are involved in the use of derivatives in risk management. These issues focus on

the reasons for using derivatives, active derivative markets and forums in which the derivatives

are conducted. However, the use of derivatives is also associated with extra risk management

issues.

DERIVATIVES IN RISK MANAGEMENT 3

The importance of using Derivatives

Corporations should focus on the use of derivatives because it has two main benefits.

These benefits are associated with programs in which the derivatives are applied. The use of

derivatives ensures that adequate risk management is achieved in markets that have both high

and low levels of volatility. The occurrences of these conditions have been witnessed since the

middle ages of 19970s. The use of derivatives is also crucial in situations where the application

of policy decisions in managing risks is inadequate (Finch, 1997). In addition, they are also

effective in situations in which the uses of transactions of the market are inadequate.

The use of derivatives is also crucial in the fund portfolio. This is because it ensures that

four issues that are associated with fund portfolios are addressed. The use of derivatives ensures

that is accessibility to the wide set of investment opportunities. The use of derivatives in the fund

portfolio also ensures that minimal disruption is experienced in the portfolio during the

implementation of views that are related to investments. The ability of avoiding the undesirable

risks is also enhanced using derivatives. Capital can also be optimized through cash outlays that

are minimal. This is applicable in the use of swaps in gaining access to the foreign markets. This

is crucial in the situation where the local settlements are either costly or difficult. For example,

markets may be characterized by high taxes, high tariffs and poor infrastructures (Finch, 1997).

In addition, there could be unfavorable policies in the market. Such markets may be difficult and

costly to investors who operate in them.

Derivative Markets

Several markets have the instruments that are associated with derivatives. These markets

are used by the institutional entities. Some of these markets include mortgage-backed securities,

DERIVATIVES IN RISK MANAGEMENT 4

Treasury bills, bonds and notes (Hadley, 2004). In addition, global currencies, commodities and

equity securities are also included in the derivative markets.

Forums of Trading Derivatives

Derivatives are traded through two forums. These include over the counter and organized

exchanges forums. The two forums have similarities in several aspects. However, they have

distinguishing features that are illustrated in the table drawn below.

DERIVATIVES IN RISK MANAGEMENT 5

FEATURES

Over-The-Counter

Exchange Traded

Example

Caps, Forwards, Floors,

Swaps and Collars

Options and futures

Market

Networks that are composed

of market makers concerned

with negotiating transactions

and exchanging price

information

Organize exchange in New

York, Chicago and Kansas

City amongst other capital

markets all over the world

Agreements

Custom structured to achieve

the needs of counter-groups

within accepted regulations

Contracts are standard

Risk

The credit risks associated

with the counter-groups

Contract performance is

guaranteed

Regulations

They are not legally

controlled

The united States exchanges

are controlled by the

commission concerned with

Commodity features trading

Ability to Value

Depends on the market

condition-some have postings

that are electronic in nature

while others need individual

valuation and inquiry.

The Intra-day prices and the

daily settlements are

conducted through electronic

posting

DERIVATIVES IN RISK MANAGEMENT 6

Extra Risk Management Issues that are linked to Derivatives

The individuals associated with the issues of the fund should be aware of the extra risk

management costs that accompany derivatives. Three issues are associated with the use of

derivatives in fund portfolios. These issues include illiquidity, risk magnification and counter

party risks. The use of some derivatives such as complicated over-the-counter may lead to

illiquidity. This may occur during the period when market stress is experienced. The derivatives

that were liquid may be transformed into illiquid derivatives in such market periods. Unlike the

securities related to cash, derivatives enable investors to expose or purchase exposure without

involving cash that equates to the economic exposure related to the position (Janney, 2004). This

situation could result into the magnification of the risk position both in the long and short terms.

In addition, the use of derivatives could also result into risks that are associated with the counter

party. This is because the benefit that is obtained from the over-the-counter is dependent on the

counterparty’s credit worthiness. The OTC derivative, therefore, are vulnerable to the counter

party risks.

Class Incidents and Activities that Facilitated the Understanding of the Topic

Several classroom activities have enhanced my understanding of the topic under study.

One of the issues is the requirement of several answers during lectures. This is crucial because it

encouraged me to understand that the topic could be addresses from several viewpoints. The

approach of the asking for several answers from the students by the teacher enhanced my

understanding. This is because I could think of other possibilities of tackling the issues that are

involved in the topic. In addition, the requirement that students expound on their answers

enabled me to understand their viewpoints concerning the issues that were being addressed in the

DERIVATIVES IN RISK MANAGEMENT 7

topic. I could be able to understand the uses of various instruments of derivatives. In addition,

the several illustrations that were issued concerning the categories of derivative instruments also

enhanced my understanding.

The provision of assignments also enabled me to understand the topic adequately. This is

because of the motivation that assignments instilled in me. In several instances, I had to conduct

a thorough research of the questions asked from the assignments issued in the class. This enabled

me to gain enough information on the topic under study. In addition, the presence of group

discussions also enabled me to learn much from the other students.

New learning Experience

The study of the topic has enabled me to be aware of both the commercial and economic

benefits that are associated with derivatives. Through the learning, I have identified that

derivatives play a crucial role in the process of risk sharing and distribution. They can be used in

the protection of businesses from exposures or risks. The events in which business may be

protected against include creditor default, shifts in the prices of assets and exchange. In addition,

the market participants can employ derivatives in speculation and risk-taking in relation to the

movement of the value of the underlying asset. This could be done without the owning of the

asset. This implies that derivatives play a significant role in the increase of credit availability and

capital flow. The use of derivatives also enables businesses to have control over the external

factors that the business cannot regulate. One of the cases that I saw over the media was in 2009.

In that year, the British Aviation (BA) was faced with the challenge of high fuel prices (Hadley,

2004). BA had 32% of the expenditure spent on fuel consumption in the 2009. The continuous

fluctuation of the fuel prices has made BA has adopted the use of derivatives in controlling the

prices. The airline ensures that this is achieved by using the futures derivative in advance

DERIVATIVES IN RISK MANAGEMENT 8

purchase of fuel. In the situation where fuel prices fall below the level that is specified in the

contract, the losses incurred on the derivatives could be settled by the lower fuel cost that was

put in a convectional way.

The use of derivatives has economic disadvantages. The disadvantages are manifested in

both the systematic and operational risks. These risks have been established to affect the

derivative contracts. Operational risks result from the errors caused by human beings. These

risks could also result from the failure of machines. Several methods can be employed to reduce

the operational risks. These methods include eradication of backlogs of derivatives that are not

confirmed and standardizations of contracts for OTC derivatives (Hadley, 2004). The physical

settlement of assets that are underlying can also be enhanced through adoption of improved

procedures and processes. These processes and procedures should be focused on the valuation of

disputes. Systematic risks are use to describe the risks related to the financial system. This may

result from the default on the part of the main player in the derivative market. The market inter-

linkages that are established by the several derivative contracts are the main cause the wide-

spreading nature of this risk (Janney, 2004). This has negative implications on the part of the

counterparty’s creditworthiness. The use of derivatives is also associated with the challenge of

Credit Default of Swaps. This is risks is often difficult to assess. This is because of the

complexities that are associated with the CDS products. The supervisors, therefore, experience

problems in pointing out dangerous distribution risks.

Current and Future Application of Derivatives

Foreign Exchange Risks

The use of derivatives in the management of foreign exchange risk is a common practice

amongst most corporations. The foreign exchange risks occur when the business outcomes are

DERIVATIVES IN RISK MANAGEMENT 9

affected adversely with the changes that result from currency exchange. The effects are always

realized when a business is involved in international trading. The multinational corporations

often suffer losses when there are fluctuations in the currencies of the foreign nations they are

involved with in trade. For example, a company could be engaged in the exportation of goods to

other countries. This company could have exported goods that are valued at a given amount. At

this amount, the currency of the nation in where the business might have exported the good could

be low. The business, therefore, could have realized profits (Ahlgrim, 2003). However, in the

situation where the foreign currency of the nation the business exports goods to rises, the

business might suffer losses. In response to this risk, the business could adopt the use of futures

contract to hedge it. This is because the rates of futures do not change in the same way as the

spot rates.

Interest Rates Risk

Companies can employ several methods to hedge the risks that are associated with

interest rates. This is may be applicable in situations where businesses expect future fluctuations

in the interest rate within given periods. This is crucial because the businesses may not be willing

to encounter losses that accompany the sale of goods without the reception of the expected cash

windfalls (Janney, 2004). When companies have expectations of future decline in the interest

rates, the purchase of treasury futures contract is crucial. This is because the treasury futures

contracts play a significant role in assisting the companies to fixing the interest rates of the

future.

Fair Value

The use of swaps can also be significant in the achievement of fair value by companies.

This is crucial in the situation involving fixed rates bonds. The alterations I the fair values of

DERIVATIVES IN RISK MANAGEMENT 10

swaps results into the compensation of the debts associated with the debts that have been hedged.

This implies companies to attain fair values could use swaps (Finch, 1997). In this situation, the

companies are involved in the use of interest rates swap. In addition, the swap is both a pay fixed

and a receive variable. The impacts of using swaps in this situation could be established because

they require companies to pay fixed interest rates that are fixed. In the process of paying fixed

interest rates, the companies could be obtaining payments that are associated with floating rates.

The amount the companies obtain from the floating payments could be used to settle the debts

resulting from the floating rates that are pre-existing (Janney, 2004). The business, therefore, is

left to cover for the debt associated with floating rates only. This implies that the businesses may

transform the obligation that is a variable rate into an obligation rate that is fixed using

derivatives.

Commodity input Hedge

The businesses that rely on the use of raw materials as inputs are often susceptible to

risks. The risks could result from the sensitivity of the raw materials to changes in prices. For

example, most of the airplanes are associated with high consumption of fuel. Focuses have been

laid on the increase in prices of crude oil by airlines because of this (Hadley, 2004). The

consideration focuses on the hedging of prices increase of crude oil. However, the airlines should

be careful with this approach. In addition, they should also conduct a thorough forecasting

because the cost associated with this strategy is high.

In conclusion, the use of derivatives in risk management is crucial. Derivatives ensure

that risks that are associated with finances are avoided. These risks may be involved in financial

markets and businesses. However, the use of derivatives is associated with extra risk

management costs. These can be prevented using several mechanisms.

DERIVATIVES IN RISK MANAGEMENT 11

References

Ahlgrim, C. (2003). An Introduction to Derivatives and Risk Management. Journal of Risk and

Insurance, 70(1), 177.

Finch, H; Fullmer, G. (1997). Evaluating On-going Projects and Divisions. Managerial

Finance,23(9), 46.

Hadley, W. (2004). A Modern View of Inventory. Strategic Finance,86(1) 30

Janney, J; Desa, G. (2004). Can Real-Options Analysis Improve Decision-Making? Promises and

Pitfalls. The Academy of Management Executive, 18(4), 60

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