Financial Risk Management - Essay Example

Businesses in order to increase the return or to reduce the level of risk associated with product (financial product) are increasingly making use of financial derivates in the respective portfolios. Among the range of derivatives being used in market following few derivatives are most commonly used (Culp, 2011): Futures contracts ( facilitating transfer of asset on future date at an agreed price) Options (Call option or put option facilitates the purchasing or selling option to buyer or seller to an agreed date and price.

To mention as the name implies options are not obligations). Swaps (Exchange of cash flow with another cash flows for gaining the required benefit) Hybrid (derivates that mix the features of more than one securities with financial engineering) Using these and others financial product of derivative category suiting to the need of the business as well as individuals financial marketers take advantage of derivatives to develop desired fashion portfolio or value of balance sheet. Derivatives allow hedging of the risks from various domains.

Such as market risk, interest rate risk, model risk etc (Functional Finances, n.d). For instance, the interest rate risk can be hedge using derivative such as Interest Rate Swap (IRS) contract. Various risk measurement factors are used to evaluate the risk such as (Hentschel & Smith Jr, 1995): Beta measures the risk in the context of equities. Stock risk is measured in relevance to the market with beta. With respect to bond market, the modified duration assess the risk associated with interest rate risk.

Interest rate risk is the relevant risk to bond. Modified risk play similar role for bonds as played by beta for equities. Delta measures the risk of change in value of future, forward or option over shorter period of time owing to the change in asset prices Gamma is a measure of change in delta as the stock prices chances. This is effective for the hedging the change in the delta. Vega measures the relationship between the volatility and options value. Rho is a risk measures for assessing the change in the call option prices with respect to the variation in the risk-free rate.

Theta is another measure for the derivatives’ risk measurement. For the change in the value of the option with respect to change in time factors (such as time to maturity) that does not abruptly changes like other factors. Hence single product of derivative (option) offers wide risk factors for hedging and these are from market risk perspectives only. Credit risk, model risk, concentration risk are other risk measures that offers greater variation in risk management for derivatives (Functional Finances, n.d). Therefore, adding derivative and hedging risk from critically valuing above mentioned risk factors can add significant returns to the portfolio while trading off higher risk to lower risk or un-affordable risk to affordable risk.

Various measures are useful in various financial conditions and even combination of measures is useful (Homaifar, 2004). For instance, a balanced portfolio (portfolio with fixed income and equity particulars) generates risk from equity segment in order to generate the higher return. In addition as the name signifies, portfolio is balance and has the fixed income