This paper examines financial derivatives as instruments for managing financial risk in modern markets. It defines derivatives and identifies the four primary types—swaps, forwards, futures, and options—before exploring their roles in hedging, arbitrage, and capital management. The paper discusses how organizations use derivatives to isolate and transfer specific risks, improve market efficiency, and pursue value-enhancing investments. It also addresses the risks inherent in derivative use, the importance of continuous monitoring, and the responsibilities of counterparties. A dedicated section covers futures and options contracts in depth, explaining their mechanics, their advantages over forward contracts, and their practical application by mutual fund managers and corporate risk managers.
Financial derivatives are an innovation in the field of finance that enable us to understand, measure, and manage financial risks. According to standard financial textbooks, a financial derivative is an instrument whose value is based on the value of one or more underlying securities or groups of securities that constitute the derivative. Three main factors account for the continuously increasing use of derivatives: the volatility of markets, deregulation, and the development of technology.
Derivatives take many forms, and options are just one example. As the name implies, these instruments are simply contracts based on, or derived from, some underlying asset, reference rate, or index. The common types of financial derivatives include any one — or a combination — of four separate types of dealings: swaps, forwards, futures, and options. These are generally based on interest rates or currencies. Some financial derivatives are traded on exchanges, while others are privately negotiated.
One of the first uses of financial derivatives was to reduce exposure to changes in foreign exchange rates, interest rates, or stock market valuations. Consider the situation of an American company that has exported goods for which it will be paid in British pounds. The company has the choice — or "option" — of entering into a derivative contract with another party to reduce the risk of the British pound increasing in value relative to the U.S. dollar when payment is made. Through the use of such an instrument, the party covering the risk is obligated to pay the exporter the equivalent value in U.S. dollars at the exchange rate established when the instrument was finalized. In this way, the derivative has shifted the exchange risk from the exporter to another party.
These instruments are continually gaining in popularity, and this growth is also increasing the variety of instruments now available. Understanding the latest uses of derivatives and the implications of the relevant transactions is essential for capturing their benefits. Derivatives are now an essential part of financial markets because of the economic functions they serve.
Financial derivatives are not a passing trend in risk management but are useful tools for reducing organizational risk. Through derivatives, an organization can break financial risks down into small components, which can then be traded on the market to meet specific risk-management objectives. The process of isolating and selling risks to those willing to accept them at the lowest cost is the fundamental function of derivatives, and this process improves market efficiency. Derivatives also permit the independent management of small pieces of risk: organizations can retain the risks they are comfortable managing and pass other risks to institutions with greater expertise in handling them.
From a market-oriented perspective, derivatives enable the free trading of financial risk. Success in handling financial derivatives depends on comparative advantage — that is, the relative costs of holding a particular risk. When an organization has a comparative advantage, an exchange is likely to benefit all parties. Furthermore, derivatives permit the trading of individual components of risk, which improves overall market efficiency.
Derivatives are also used to expand product offerings to customers, to trade for profit, to manage the costs of capital or funding, and to alter the risk-and-reward profile of a particular item or the organization as a whole. Businesses use derivatives not only for hedging and arbitrage but also for improving their competitive edge. This has led the theoretical framework of derivative instruments to flow into many seemingly different areas, such as project evaluation, instrument design, and performance evaluation techniques.
One recent application of derivatives is the separation of different categories of investment risk according to their appeal to different investors, such as mutual fund managers, corporate treasurers, or pension fund administrators. Different investment managers may find that assuming different risk characteristics of certain securities best suits their strategies. For example, some debt securities may consist of a large number of residential home mortgages. One derivative might focus only on the interest payments made on those mortgages, while another might concentrate on the repayment of principal. These derivative products will react differently to movements in interest rates and may therefore have different appeal to different investment strategies and managers.
The enormous growth of the financial derivatives market — and the major losses that have occasionally accompanied it — has generated considerable confusion about these instruments. While the legitimacy of derivatives is not in doubt, nor is their value for banks, they nonetheless carry risks that must be managed. There is nothing unique about managing these risks; methods for addressing them should be built into the risk management structures of banks. The basic risks of derivatives — timing and variations in cash flows — are the same as those present in other financial activities. Critics of financial derivatives fear that they could trigger a large-scale financial disaster, stopping world financial markets and forcing government intervention at the taxpayer's expense. Such critics believe the risks created by derivatives are uncontrollable.
Like all tools, derivatives require users to understand their intended function and take necessary precautions before using them. Derivatives are instruments for shifting risk, and before using them one must identify and understand the risks being assumed. Those risks must then be evaluated and continuously monitored. All parties to a derivative contract must understand and evaluate the full range of risks involved before entering into the contract. Part of that process involves determining the monetary exposure of each party as defined by the derivative instrument.
Because payment is not due until the specified date of performance, this absence of immediate cash liability may obscure the ultimate financial responsibilities involved. Investors and markets have traditionally relied on rating services to assess credit and investment risks for debt instruments, but no equivalent system exists for derivatives. This has led some commercial firms to issue ratings on company securities that also evaluate the company's exposure to derivative financial instruments when the company is a party to them.
The creditworthiness of all parties to a derivative must be independently evaluated by the others involved. For derivative transactions, the capacity of all parties depends substantially on the strength of their individual balance sheets. This makes a thorough financial investigation of any proposed counterparty essential. Another important but often overlooked aspect of derivative use is the need for constant monitoring and managing of the risks embedded in the instrument. Entering into a derivative transaction is not like purchasing an equity or debt security, where paperwork can simply be filed away. Derivative instruments establish ongoing relationships that require regular monitoring for signs of unacceptable change.
"Aligning derivative use with corporate strategy and goals"
When used correctly, financial derivatives can help organizations achieve their risk management objectives and ensure funds are available for worthwhile investments. It is therefore unsurprising that profits from derivative products have contributed to a massive rise in non-interest earnings at large banks, and have played a role in the significant growth of the finance industry's share of total American corporate output over the past decade.
U.S. commercial banks are the largest participants in the global derivatives market. In 1999, they reported outstanding derivative contracts with a notional value of $33 trillion, a level reached from 1990 through continuous compounded annual growth of 20%. Bank holding companies may also be permitted to take or make delivery of title to commodities underlying derivative transactions. They should also be allowed to participate in established derivatives markets where assignment, termination, or offset is not permitted in documents. Both bank and non-bank users of these instruments have shown a growing tendency to use them as a core component of their capital risk allocation and profit maximization strategies.
When a firm decides to use derivatives as a risk-management strategy, it should consider its broad corporate objectives carefully. When the risk management strategy is unclear, the use of financial derivatives can be dangerous and may undermine the firm's long-range objectives while also leading to unsafe and unsound practices. The end result could be insolvency. Used intelligently, however, financial derivatives can increase shareholder value by providing better control of risk exposures and cash flows, reducing uncertainties, and enabling organizations to enter production areas they might otherwise have avoided.
Organizations should use derivatives to actively identify specific risks while hedging unwanted exposures. They should retain the risks they are comfortable with and transfer others to willing counterparties. When using financial derivatives, organizations should employ only instruments they understand and that align with their existing corporate philosophy for managing risk. As most experts agree, while derivatives can easily be used for speculation, their broad adoption in conventional finance demonstrates the substantial benefits they can provide. Ignoring those benefits may mean forgoing a wide array of advantages these instruments offer. Financial derivatives must be part of the risk management strategy of any business committed to fully pursuing value-raising investment opportunities.
Most current financial innovations focus on hedging complex risks to reduce future uncertainties and improve risk management. Futures contracts are designed specifically for this purpose. A futures contract represents the right to buy or sell standard quantities of assets or securities of accepted quality at previously specified dates and prices. The purpose of futures is not always clear to those who believe forward contracts are sufficient for risk management. However, an innovation will not survive unless it provides additional value, and the high trading volumes of futures contracts in global markets are themselves evidence of their advantages over forward contracts.
Futures contracts for instruments other than physical assets or commodities developed after the financial deregulation of the 1970s. The first futures contracts introduced were for foreign exchange rates. The International Monetary Market of the Chicago Mercantile Exchange (CME) began trading the first financial futures in May 1972. These contracts covered the British pound, Canadian dollar, German mark, Dutch guilder, Japanese yen, Mexican peso, and Swiss franc.
Futures contracts were developed in part to address the shortcomings of forward contracts. A futures contract is cleared through the appropriate exchange. Settlement is typically in cash or a cash equivalent, and physical delivery of an asset is usually not required. Parties to futures contracts may also buy or write options on futures. Because today's markets require anonymous trading with high competition and liquidity, futures contracts are standardized by exchange clearinghouses. An additional advantage is that futures are marked to market daily, which reduces counterparty risk — the risk that the other party will be unable to meet its obligations when the contract matures. The design of futures ensures that risks related to the uncertainty of future market prices of the underlying asset are shared by both buyers and sellers. When the contract is finalized, both parties have full knowledge of their future positions, which helps them manage their financial resources.
Many managers take futures positions for purely speculative reasons. For example, if a party sells an uncovered futures contract — meaning they hold no long position in the underlying asset — a fall in the price of the asset will generate a profit for the speculator, while a rise will produce a loss. The novation principle is used to overcome counterparty risk: because the exchange acts as intermediary, it guarantees each deal by acting as the buyer for every seller and the seller for every buyer. Each party effectively transfers its counterparty risk to the exchange. The exchange manages this transferred risk through a margining process and through the daily marking to market of positions.
"Calls, puts, option types, and pricing complexity"
"Practical use by fund managers to hedge and enhance returns"
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