RISK MANAGEMENT

Use of Derivatives in Risk Management

[Name of the instructor]

Use of Derivatives in Risk Management

Introduction

A derivative is like a razor, you can use it to shave and make yourself attractive for your girlfriend, you can slit your throat with it or you can use it to commit suicide.

This statement describes to us the problems, and on the other hand rewards, that the proper use of derivatives can bring. The derivatives market has developed responding to the uncertainty about prices, and therefore provided a means of separating out this price volatility. The tendency of the market to move up or down in what appears to be a random manner has brought about the need for financial products which will protect or hedge the investor against the ill effects of market volatility. Certain types of derivatives called Futures and Options might do just that if used properly. In this essay we look at certain types of derivatives called Futures and Options, and how hedgers / investors make use of them to their advantage as well as where the threats seem to lie when dealing with them in general (Piesse et al., 1995).

These derivative markets allow hedgers to avoid risk by transferring it to speculators who seek it. We have all heard the phrase keep your options open and it is along these lines that the Options derivative has arisen. As we know options are contractual arrangements giving the owner the right, but not the obligation, to buy or sell something at a given price, at some time in the future. It is these Options in general that we want to address as they offer the investor the ability to create a wide variety of risk and return alternatives from the same underlying security. Futures, being exchanged-traded forward contracts, have also provided another choice to suit the needs of the holder and the advantages for and against these will also be looked at.

After looking at the Futures and Options we will turn our attention to discussing the cases for and against the needs of further regulating this market. This issue has been strongly reinforced since many big bets have gone wrong, such as the collapse of Barings and many others. Where do the faults lie which have led to these disasters and who if anybody is to blame? These are matters that will need to be looked at. To begin with let's focus our attention on Futures contracts (Lewis, 1989).

Advantages / Disadvantages from the use of Future Contracts

- As the market for future contracts is standardized and traded on the Stock-exchange (LIFFE) then a secondary market can exist and can be traded through the usual transaction mechanisms.

- Holder of a futures contract is locked in an effective selling price therefore if he sells the contract against their position and then sees the market go up rather than down, he cannot take advantage of that upswing.

- If an investor wishes to take advantage of favourable yields but is aware ...