Managing Risk with Derivatives - Essay Example

This paper attempts to discuss derivatives as a tool for financial risk management and its effectiveness in business risk management. In the finance literature, hedge refers to a technique in which an investment is made in certain securities to reduce or eliminate the risk of loss resulting from the fluctuations in the price of another security by taking two offset positions in the related security. Hedging is defined as a risk management strategy designed to offset risk of loss causing from fluctuations in the prices of commodities, currencies or securities ( LiPuma, 2004).

Hedging helps to transfer the various risks without the need of buying any insurance policies. Hedging was commonly used in the commodities market by the traders to reduce the risk of loss caused by fluctuations in the price of a commodity. It was used by the trader to buy as well as sell the equal quantities of the same commodities in two different markets at same time with the expectation that a change in price in future in one market will help to offset by an opposite change in the other market.

But now hedging could also be used in the securities and foreign exchange market. Source: One of the instrument or tool used to hedge risk is derivatives. . Derivatives refer to the financial contracts or instruments that derive their value from the underlying asset like stocks, equity, bonds, commodities etc. Nowadays derivatives are also used by the investors and institutional borrowers. The people who use derivatives as a way of managing risk are called hedgers. The derivative instruments used for hedging purposes include forwards, futures, options, swaps and combination on these (hybrid).

Derivatives are becoming increasingly important in international markets as a tool for risk management. Derivatives help lot to the corporate clients to separate their risks and transfer them to those who are ready to bear their risks. In addition to these derivatives are the cheapest and convenient means of hedging because in derivatives there is no actual delivery of underlying assets only the profit or loss on the derivative contract is adjusted. Moreover all the derivative instruments are very simple to operate without any tedious process in it.

They can also be used by the companies to hedge their long tern risks (i.e., 10-15 year risk), which enable the companies to focus more on management decisions other than funding decisions. Further all derivative instruments are low cost products and offer high liquidity to the companies. Due to these reasons derivatives have become one of the essential tool for the companies to hedge their complex exposures and volatilities that they have to face in the financial markets today. However it is seen that the derivative instruments in recent times have come under general scrutiny because of its misuse made by the companies in managing the financial risks.

Hence depending upon how it is used the derivatives can be both advantageous