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Financial derivatives are an innovation in the field of finance that enable us to understand, measure and manage our financial risks. The definition of financial derivative according to the textbooks is of a financial instrument, and the value of any financial derivative is based on the value or values of the underlying securities or groups of securities that constitute the derivative. It can be said that there have been three main reasons for the continuously increasing use of derivatives now. These are the volatility of the markets, deregulation and development of technologies. There are also many shapes of financial derivatives, and options are just one form. As is clear from the name 'derivative', the items are just contracts based on or derived from some underlying asset, reference rate or index. The common types of financial derivatives are any one, or a combination of four separate types of dealings which are swaps, forwards, futures and options. These are based on interest rates or currencies. Some financial derivatives are traded on exchanges and others are privately negotiated.
Roles of financial derivatives
One of the first uses of financial derivatives was to reduce exposure to changes in rates of foreign exchange, interests, or stock market valuation. As an example take the situation of an American company has sent goods for which they will be paid in British Pounds. It has the choice or 'option' of entering into a derivative contract with another party to reduce the risk of British Pound increasing in value compared to U.S. Dollar when the payment is made. Through the use of the instrument, the party covering the risk is compelled to pay the exporter the value in American Dollars at the rate at which the instrument was finalized. Thus the derivative has shifted the exchange risk from the exporter to another party. These instruments are continually gaining in popularity and familiarity, and this increase in popularity is also increasing the variety of such instruments that are now available. One has to understand the latest uses of derivatives and the implications of the concerned transactions to get the benefit from these instruments. Derivatives are now an essential part of the financial markets due to the economic functions they can serve.
Financial derivative is not the latest crazes for risk management, but is a useful tool for reducing the risks of organizations. Financial risks can be broken down into small components by an organization through derivatives. These components can then be traded on the market for meeting the required risk-management objective. Thus the risks are being isolated and sold to others willing to accept the risks at the lowest cost is the job of derivatives and the process improves market efficiencies. Independent management of small pieces of risks is permitted by the use of derivatives. Organizations can take the risks that they are comfortable in managing and pass on the other risks to other institutions that have more expertise in handling them. Looking at a market oriented angle, the free trading of financial risk is provided by derivatives. The success in handling financial derivatives is based on comparative advantage and that is in terms of the relative costs of holding the risk. When an organization has a comparative advantage, then the exchange is likely to help all parties. Further when we look at the question from the view of the market, derivatives permit the trading of individual components of the risk and this improves efficiency of the market.
Derivatives are also used in expansion of the product offerings to customers, trade for profit, manage the costs of capital or funding and change the profile of risk and rewards for a particular item or the picture of the organization. Derivatives are used by businesses not only for hedging and arbitrage but also for improving the marketing edge. This has led to the flow of the theoretical framework of derivative instruments into many apparently different areas like project evaluation, instrument design, performance evaluation techniques and so on. One of the recent uses of derivatives have been for the separation of different categories of investment risk according to their appeal for different investors like mutual fund managers, corporate treasurers or pension funs administrators. The different investment managers may feel that assumption of different risk characters of certain securities suit them best. As an example of this, one can think of some debt securities may consist of a large number of residential home mortgages. In this also there may be one derivative regarding only the interest payments made on mortgages while another may concentrate on the payments of principals. These derivative products will react in different manner to movement in interest rates and thus may have different appeal to different investment strategies as used by different investment managers.
The huge growth of the market of financial derivatives and connected major losses of the derivative products have led to a lot of confusion about these instruments. While the legitimacy of derivatives is not in doubt, as also their value for banks, still, at the same time, they have risks to be managed. There is nothing unique or singular about managing these risks, and methods for dealing with them should be built into the risk management structure of the banks. The risks are also nothing new or exotic. The basic risks are the same as those which exist in other activities. The basic risk of derivatives is a matter of timing and variations of cash flows like all other financial instruments. The opponents of financial derivatives feel that there will be a financial disaster of large proportions from them. This could stop the financial markets in the world and then force the interventions of governments so that economic collapse does not occur - all this to be done at the cost of the taxpayer. The risks created by derivatives are believed to be uncontrollable by the critics.
Like all tools, it is important that the user of the tool understand the intended function of the tool and take required precaution before using the tool. Derivatives are devices for shifting of risk, and before using them one has to identify and understand the risks that are being taken on. Then the risks have to be evaluated and checked on continuously for management. The different parties to a derivative contract have to understand all the involved risks and evaluate them before entering into the contract. Part of the risks to be identified is determining the monetary exposure of the parties as given in the derivatives instrument. The money is not payable till the specified date of performance in terms of the obligations of the parties. This lack of any liability for immediate payment of cash may hide the ultimate financial responsibilities. The investors and markets have usually looked to different rating services for the judgment credit and investment risks for debt, and nothing similar is present for derivatives.
This has led some commercial firms to issue ratings on company securities and that is also an evaluation of the company's exposure to derivative financial instruments in cases where it is a party. At the same time, the creditworthiness of all involved parties in a derivative instrument has to be independently evaluated by the others. For the derivatives, the capability of all parties is a lot dependent on the strengths of their individual balance sheets. This makes it essential that an investigation of any proposed counterparty is properly financially investigated for any derivative. Another important but overlooked aspect of use of derivatives is the requirement of constant monitoring and managing of the risks represented in the derivative instrument. Entering into a derivative transaction is not like the purchase of equity or debt security where the paperwork can just be stored and forgotten. The derivative instruments establish relationships which require regular monitoring for signs of unacceptable change.
The size of the trading institution does not dictate the economic benefits of derivatives. The strategic objectives of a company should determine whether it should use derivatives or not, and is not related to the size. For any risk management strategy, it is important to ensure the availability of necessary funds for the pursuit of value enhancing investment opportunities. At the same time, all users of derivatives, irrespective of size should be aware of the structuring of their contracts, the special price and risk characteristics of their instruments and the expected performance of the instruments under stress and volatility in economic conditions. The prudent risk manager will adopt a strategy to help the organization achieve corporate goals and will use market simulations and stress tests. This is the essential prior requirement for the use of financial derivative products. When they are used correctly, financial derivatives can help organizations to achieve their objectives for risk management and that will ensure funds for worthwhile investment. Thus it is not a surprise that the profitability from the derivative products have caused a massive rise in the non-interest earnings in the large banks. This is also…[continue]
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