Derivatives in Risk Management One of the Research Paper

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Derivatives in Risk Management

One of the uses for derivative products is in risk management. Organizations have recognized that derivatives can be used to manage risk by offering guaranteed outcomes for a set up-front cost. For firms that face risk due to fluctuations in asset prices -- typically commodities or currencies -- beyond their control, derivatives represent a means of achieving cash flow certainty, if not profit certainty. This paper will explore the different forms that derivatives take, and the different ways in which they are used as a risk management tool. Some recommendation will be given with respect to the use of derivatives in risk management in order to optimize results.

Derivatives and Risk Management

In finance, a derivative instrument is one that has a price that is based on the price of a real underlying asset -- agricultural commodities, metals, sources of energy, currencies, stocks and bonds (Chance & Brooks, 2008). Each of these assets is subject to market price fluctuations. While theoretically at least these fluctuations reflect the intrinsic value of the good on the world market, mathematically they are random, reflecting the "divergent anticipations and conflicting interests" that render them unpredictable (Bouchard & Potters, 2003). When an organization has a financial stake in the value of an underlying asset, the unpredictable fluctuation of the value of that asset can be detrimental to other elements of the normal conduct of business. For example, profitability can be affected by changes in the value of foreign currencies between the sale of a good and the receipt of payment for that. Pricing strategy is also affected.

A classic example is in the airline industry, where competition is intense and consequently margins are razor-thin. Fuel prices are roughly a third of the cost structure of airlines, and they are highly volatile. When airlines set ticket prices in line with the competitive dynamic of the day, they are also taking into consideration the expected future fuel price, ensuring that the ticket price they set allows them to operate the flight profitably. Fluctuations in fuel prices can remove profitability from that flight, especially given the thin margins and high volatility of fuel prices (Snyder, 2011).

The use of derivatives as a risk management tool reflects the use of derivatives to lock in the value of future cash flows today. Bodnar, Marston and Hayt (1998) found that half of all businesses use derivatives to manage risk, and 68% of primary product firms did so. Firms tended most frequently to hedge their foreign currency exposure. Most firms, however, only hedged a portion of their foreign currency exposure, and only for the short-run of less than 90 days (Ibid). Most firms reported being concerned about counterparty risk on longer derivatives, influencing their decision to only hedge short-run exposures. Hedging refers to the practice of using derivatives to lock in the value of future cash flows (i.e. risk management). In addition to currencies, companies hedge interest rate risk, commodity prices and to a lesser extent equities.

There are a number of methods by which organizations can use derivatives for risk management. Futures, calls and puts are all traded publicly on exchanges, facilitating basic risk management using pre-set amounts. While it is difficult to get a perfect hedge using publicly-traded derivatives, few firms seek a complete and perfect hedge anyway. There is also significant benefit to using market-based risk management because of the inherent liquidity and transparency of derivatives markets. Methods such as swaps, forwards and more advanced, structured forms of risk management may lack liquidity and transparency, but are possible through the use of intermediaries, typically the company's bank. Any option has a transaction cost that represents the primary opportunity cost of the technique. Further, there is usually some degree of counterparty risk, that the other party in the deal will be unable to fulfill its part of the bargain. Typically, this leads to major banks as counterparties, rather than smaller banks or other corporate entities.

Locking in future cash flows carries with it some risk of its own. The unpredictable nature of price fluctuations in market-based assets means that a company is as likely to "win" as it is to "lose" on a hedging transaction. For example, if an airline buys futures to hedge fuel prices, and the price goes up, the airline will win because the price it paid will be less than the market price at the time of purchase. However, if the price goes down, as in the second half of 2008, the airline will book a significant loss (Rivers, 2012). The use of derivatives in risk management therefore does not guarantee the organization a profit or a "win," but merely implies that future cash flows will be predictable.

There are other factors involved in the degree to which an organization will use derivatives for risk management. The first is the amount of risk management that the company deems necessary; the second is the level of comfort that the organization has with derivatives. Bodnar (1998) notes that most companies have centralized their risk management functions, taking this practice away from functional managers. In addition, there are concerns about counterparty risk that affect a company's likelihood of using derivatives in risk management. There are also concerns about things like accounting treatment -- though most managers seemed relatively unconcerned with stipulations regarding the fair value measurement of derivatives (Ibid). Secondary market liquidity is another concern limiting the use of derivatives in risk management.

As a result of these different factors, companies will often only use derivatives to a limited degree; they seldom seek perfect hedges and may only hedge a small fraction of their total exposure. There is also some systemic risk, as noted by Hentschel and Smith (1995) and seen in ample evidence with the market failure in credit default swaps in 2008. Further, firms might only hedge to the degree that they feel they will benefit from the certainty that the hedging brings; a function of the opportunity cost of hedging.

In addition, derivatives are just one risk management tool available to organizations, so they are inherently going to play a limited role in any organization's overall risk management strategy. Most forms of risk -- such as political risk, economic risk, liability risk and more are difficult to hedge using derivatives. Firms use other tactics, ranging from diversification to strategic alliances -- to address other forms of risk. In many organizations, these other forms of risk might be more significant than the forms of financial risk that can be management with derivatives. Thus, the role that derivatives might play in the overall risk management strategy could be minimal, if the financial risk the firm faces is relatively insignificant.

Facilitating Understanding

The way I learn is to absorb the information, and just to study. I learned these concepts mostly through the examples in the readings, and through relating them to my own experience. Taking something like the airline example gives the subject some real world perspective, and there is ample writing about fuel hedging at airlines on the Internet. Once I started to understand the basic theories, it was easy to see how most types of derivative use for risk management could easily be applied to everyday business.

One topic that seems to be a gap, even still, is the issue of hedging equities. Certainly, some companies do own equity or bond investments -- companies like Apple or Google have invested their cashpiles in a variety of investments, and there are times when firms own equities as the result of takeovers. However, the idea of hedging equities seems more applicable to individual investing, yet Bodnar et al. (1998) note that over one-quarter of firms hedge their exposure to equities. In general, I have found that I understand these concepts mainly be investigating how the concepts would be applied in the real world. Understanding certainly is not facilitated by complicated mathematical models or theoretical underpinnings -- the real world is the way that I responded to the best.

Applications to the Workplace

It is not hard to see how a financial manager would see derivatives as a great opportunity to lock in the value of future cash flows, and to hedge against exposure to volatile assets. The degree to which these risk management strategies affect different areas of the organization is perhaps something that would make for interesting future study. I can tell that there is a significant amount of study on the mathematical implications of hedging, both from the math and finance perspectives -- but clearly these decisions are made at a broader level within the organization. That the risk management function is largely centralized -- at least with respect to financial risks -- indicates as much. What interests me is that these decisions can affect everything from pricing decisions to the ability to enter a foreign market, to a company's financial outcomes -- therefore affecting shareholders as well. The accounting department becomes involved when the value of the derivatives -- or even the…

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