Financial Derivatives: Risk Management with Futures and Options

Introduction to Financial Derivatives

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.

Roles of Financial Derivatives in Risk Management

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.