Use of Derivatives in Risk Management



Use of Derivatives in Risk Management

Introduction

The derivatives are considered as a financial instrument in which value of an instrument is dependent on the essential asset, securities and shares. The formal definition of derivatives states that a derivative is a contract that is incurred between two parties as per specified terms and conditions such as monitory value, interest rate, time period etc. in which each party is liable to make certain amount to other (Hull, J. C., 2006). Derivatives are the most widely instruments used to manage risk faced by the business. These financial instruments are highly desirable for managing high and moderate level of market volatility as the market has been volatile since the mid of 1970s. The use of derivatives in managing risk is also acceptable due to restricted ability of the policy related decisions to cater or hedge the risk exposure (Strategies & Tactics, 2008). Therefore, it can be said that the unpredicted changes in the world of business and increase in level of volatility in the market in form of interest rates, exchange rates, has a greater impact on the risks like that of financial and credit faced by the organizations domestically and internationally. These risks have higher tendency to impact profits, and its ability to survive in the industry.

The financial and credit risks are the two most threatening risks for the businesses in terms of survival and profitability. As per report of Bank for International Settlement,4% of contracts in 2010 valued $601 trillion in the first half only at over the counter market and this value was increased by 3% in the second half of the year. As per the survey conducted by International Swaps and Derivatives Associations 94% of the major organizations in the world utilized derivatives to manage business and economic risks. Furthermore, the foreign exchange and interest rate risks derivatives are considered as the most common derivative instruments used world wide. The corporations through out the world are exposed to financial risks like that of market, credit, liquidity and insurance risk on daily basis (Hone, T., 2012).

Discussion

The usage of derivates by the non-financial firms is also a rising trend that has been observed largely in many countries for the past few years. Usage of derivatives is an important aspect in the markets to reduce the risk in the firm's operation. The derivative is the financial instrument that is generally used by the firms in order to protect them from different risks. It can be said that the derivatives are used for deriving the definite value of any commodity. These are the future contracts between the buyer and seller that must take place in the future.

The derivatives are usually based on the future date on which the agreement has to be sold among the buyer and seller. It involves the buying or selling of the underlined that can be specified as any tangible or intangible good. It can include any tangible commodity like oil or flour and ...