RISK MANAGEMENT

Financial Derivatives and Risk Management

Financial Derivatives and Risk Management

Introduction

A derivative instrument or a financial derivative is a financial product whose value is based on the price of another asset. The assets of the dependent take the name of the underlying asset, such as the future value of gold based on the price of gold. The underlying use of derivatives can be very different ranging from shares, stock indices, and fixed income securities to interest rates or even raw materials (Sill 1997, p. 21). The rise of derivatives markets in recent years has been spectacular, caused primarily by its use to cover risks. This paper presents how hedging with a derivatives strategy may provide adequate risk management for companies. The paper also presents case examples of BMW and Lufthansa to demonstrate how hedging through derivatives have helped them maintain financial prudence.

Discussion

Hedging refers to the reduction of an existent risk by the elimination of exposure to price movements in an asset. Hedging stabilizes markets since it removes potential shocks to balance sheets that can destabilize the financial system. Also, if hedging is complete at the aggregate level, long and short positions can be matched with less price volatility (Christoffersen 2003). Those taking a short position want to sell an asset because they believe its price is going to fall, while those going long want to buy it since they expect a rise in the asset price. Unhedged short-term foreign borrowing played a major role in escalating the East Asian crisis of 1997-98 (Dubofsky 2003 25).

Currency risk is hedged through contracts that protect the home currency value of transactions denominated in a foreign currency, removing the exposure to exchange rate fluctuations (Buckle & Thompson 2004). The currency risk is transferred to another party who wants to take an exposure in opposite direction. Currency risk can be managed by financial derivative effectively. The general characteristics of financial derivatives are:

Its value changes in response to changes in price of underlying asset. There are derivatives on agricultural and livestock products, metals, energy, currencies, stocks, stock indices, interest rates, etc.

It requires very little initial net investment or no regard to other contracts that have a similar response to changes in market condition, allowing higher profits as well as higher losses.

A derivative is settled at a future date.

A derivative may be quoted in organized markets (like bags) or unorganized form like over the counter transactions (OTCs).

The value of a derivative hedging contract is based on the underlying basic spot exchange rate. Standardized contracts are available, or customized (over-the-counter, or OTC) contracts can be designed (Dubofsky 2003 26). An Indian exporter, for example, can sell the dollars due to him in the future on the dollar-rupee forward market, through a forward contract or an agreement to sell the dollars at a certain future rate for a certain price reflecting current prices. Hedging can also be accomplished informally, for example, if an exporter takes a foreign loan (Edwards and Cantor 1995, ...