Use of Derivatives in Risk Management - Term Paper Example

? Financial Risk Management Financial Risk Management Introduction Risk is a legitimate part of business activity because of the globalized volume of corporate structure. Multinationals are working in various foreign countries due to saturation of the local markets. However, these international markets differ in their outlook on risk, profitability and security. Therefore, sensible businesses deploy divergent risk aversion techniques in order to counteract corporate risk. This paper will analyze various forms of risk handling instruments which are used to increase the level of business certainty. Following are the major sorts of instruments applied by organizations to manage the financial risks associated with business activity. Futures and Options In this type of instrument, one individual or business signs a contract with another one to purchase the commodity on some future date with an agreed-upon price (Benson & Oliver, 2004). However, in futures both of the parties have to go through with the contract while in options both of the parties reserve the right to withdraw the contract upon paying in monetary terms. They are also regularized by governments and thus involve governmental representatives. Agreements This instrument is localized in nature, and governments do not interfere with its transactions. Nevertheless, the purpose of these agreements is the same as that of futures and options, which is to hedge against fluctuations in the market price of the commodity or an industrial product (Jing, 2010). It is also important to note that these kinds of agreements are more common in economically distressed nations. But, recently they are intensively deployed in order to ensure a supply of raw material in US, which is necessary because of the prevailing recession in the local market. So, it is safe to assume that businesses are preparing themselves for increasing adversities of the future by contracting with their suppliers on a long term basis, which also enables them to attain economies of scale as a result, driving their financial and operational costs down that allows them to lower their prices in order to increase their market share. Nevertheless, it is fascinating to acknowledge that various businesses are paying close attention towards managing financial risk through using statistical models in order to assess the current level of risk, which can disrupt the expected pattern of their cash flows (Benson & Oliver, 2004). However, they often lack the proper translation of this analysis into practical plans, so in this way they cannot benefit from the concept of derivatives effectively most of the times. On the other hand, manufacturing sector of Europe is using derivatives more extensively than American ones (SpricIc, 2007). The prime reason for this trend is prevailing and growing uncertainty of the European market as compared to that of America. Along with this, managers who deploy derivatives in order to evaluate the degree of risk in financial terms are viewed as trustworthy by stockholders because they consider it as the proper and desirable means of minimizing financial threats (Koonce, Lipe, & McAnally, 2008). However, managers are found to falter by not basing their business decisions on the results of derivative analysis, therefore portraying the image of rational business decision making when in reality it is not the case. At the same time, derivatives are not rated as an effective mean for minimizing the possibility of default (Yi, Lin, & Chen, 2008). Therefore, derivatives can only be utilized as the mean of predicting future financial position of a particular firm. However, it is important to note that firms that base their decisions on derivative analysis often outperform those that do not consider derivatives as an ideal method for predicting financial future (Lin, Pantzalis, & Park, 2009). Another advantage of successful risk management is contentment of stockholders (Berk, Peterlin, & Cok, 2009). Through effective management, risk managers can handle them and are able to satisfy the most important goal of maximizing shareholders wealth. It is relieving to know that firms in developing nations are deploying modern methods of hedging against the risks and are therefore well aware of the conditions prevailing in the local market. However, they are lacking specialized knowledge of finance (Yadav & Rastogi, 2009), which is hindering their ability to minimize the risks of corporate world effectively and efficiently. Nevertheless, nations such as India are working hard to perfect their risk management and they will achieve it with the lapse of time. Banks are using derivates to quantify the expected change in interest rate of governmental central monetary authority in order to decide the level of their financial spread (Jing, 2010). Therefore, banking is one of those industries besides operational management which are effectively deploying hedging and derivative techniques to their advantage. However, it is also important to note that the usage of derivatives to counteract financial risks are turning into a globalized practice because it significantly helped organizations in maximizing their profit margins in the past (Rivas, Policastro, & Ozuna, 2010). Therefore, excellent financial management skills are counted as one of the desirable skill for every manager working across various industries. However, board of directors also attempt to foster high-end financial management skills in their subordinates (Adams, Lin, & Zou, 2011) so that they can readily analyze a proposal in terms of its financial viability. Along with this, directors like to develop teams of financial analysts in order to avoid the possibility of a human error in the process of financial management and decision-making (Chen, 2011). Derivatives are used as a tool to revert risky situations into profitable ones in various financial institutions. So in the light of this observation, derivatives are designated as the important managerial need in modern corporation era. Derivatives, in addition to higher cognitive ability, can serve its intended purpose minimizing business risk (Bartram, Brown, & Conrad, 2011) because if top and middle management of the organization cannot extract meaningful information from the use of derivatives, the organization often fails to manage risks associated with business activity. On the other hand, if organizations develop their financial statement with accuracy, this practice will increase its strength against risks (Lins, Servaes, & Tamayo, 2011) because, firstly, its stakeholders will be well informed about its performance; thus, their trust in the management team will grow substantially. Secondly, organization’s internal departments will also have sufficient knowledge about the current situation of the company; therefore, it will make them able to respond to changing business needs with effectiveness. A profound study holds that organizations should work to manage their operational risks, which in turn reduces financial ones because both risks are interwoven (Hankins, 2011). Hence, managers do not have to allocate resources in order to minimize financial costs. In the light of the above mentioned studies, it becomes evident that firms should analyze the nature of risks in order to cope with them (Kaplan & Mikes, 2012) because misidentification of intimidation can lead to ineffective allocation of resources. Organizations also deploy risk management techniques in order to minimize risks of obsolesce, breakage and other similar ones (Machowiak, 2012) so that they do not have to face increasing inventory costs. However, for this purpose, firms maintain a minimum stock level so that they can minimize the possibility of a stock-out. Along with this, organizations are also resting upon just-in-time inventory, which allows them to reduce carrying cost as well. Nevertheless, those individuals whose personality is characterized with fear of failure, which consequently hinders their ability to manage finance (Sage & Grable, 2010), are not considered as ideals for financial management. In traditional finance, it is considered unwise to store money for long term because of inflation (Fathi, Zarei, & Esfahani, 2012). Therefore, businesses are reinvesting their profits within their current activities so that money can provide them with sustained return. However, few management scholars challenge this approach on ethical grounds because in order to reinvest profits companies do not pay regular dividends and thus lose the trust of their investors. In the light of this argument, it can be established that organizations should provide dividends as regularly as possible. On the other hand, organizations are not reporting their true financial performance increasingly, and shareholders are deprived of their legitimate right for dividend. Therefore, government should vigorously analyze and scrutinize the financial practices of the organizations working in various industries (Gates, Nicolas, & Walker, 2012). Based on the above discussion, I learned various facts about practices in modern financial markets, which are as follows: 1) Financial risk management is a necessity for modern businesses to survive in the competitive marketplace; 2) In order to successfully handle all the financial risks, companies should understand their nature; 3) At the same time, companies should keep analyzing governmental financial policies, so that they can respond to any change immediately; 4) Financial management is an appropriate field for dynamic and confident people; 5) Use of derivatives as a source of hedging financial uncertainty is effective in banks; 6) Organizations which do not consider financial management as a critical part underperform; Besides, I also understand the implications that top managers’ personalities have on organizations’ ability to minimize financial risks because organizations with financially enlightened management outperform those with ordinary monetary management. In this fashion, the importance of strategic financial management is highlighted. On the other hand, HR practices should also recruit and select those people with appropriate skill set for finance and accounting department in order to optimize the performance of finance department. Along with this, I got sufficient information about the ethical dilemmas prevailing in the international business practices where organizations do not care about their shareholders. At the same time, I came across the fact that organizations are using depreciation as a tool to avoid taxation and in extreme cases showing losses when, actually, substantial profits are made. However, the prime argument of this paper stated that hedging and risk management are taken seriously in developed nations, whereas developing ones are lacking expertise in this particular field of management. Along with this, governmental organizations are lethargic is employing advanced strategies of financial management whilst private ones are more than willing to use them as strategic tools. In parallel, organizations should also develop a proper balance between their overall strategy and their financial strategy in order to maximize their performance in terms of maximizing the shareholder wealth. Along with this, organizations ought to offer their employees profit sharing and other similar benefits such as health and life insurance so that they can work to their full potential to fulfill intended organizational goals; however, the role of effective leadership on the behalf of top management towards inspiring employees should not be underestimated. Thus, we are dealing with the transformation of finance from something entirely focusing on numeric factor of an organization towards the field that now takes the personality type of the managers in account before highlighting appropriate financial strategies. In this way, I came to know that financial management is not about leverage and other concepts only but also concerns about the behavioral factors. Conclusion This paper focused on analyzing the main features of financial risk management which prevail in the international market. It is stunning to know that risk management is the critical practice in economies with low uncertainty while the ones rated high on this scale do not consider it important at all. In this way, developing nations are struggling to develop efficient financial skills. At the same time, financial reporting does not share true information with the stakeholders; therefore, they are usually misinformed about the current situation of their company. Hence, government should intervene to keep these organizations on solid ethical grounds. At the same time, financial management is turning into a field which accounts for behavioral aspects of the managers as well Based on the reviewed literature, it can be concluded that financial management is plagued with unethical practices which enable organizations to operate without paying dividends regularly. However, risk management is growing in terms of its application across various industries. Therefore, it can be implied that financial risk management will be accepted as a legitimate practice in both developed and developing nations. Thus, risk management will be accepted as an important aspect of management in future. References Adams, M., Lin, C., & Zou, H. (2011). Chief Executive Officer Incentives, Monitoring, and Corporate Risk Management: Evidence from Insurance use. The Journal of Risk and Insurance 78(3) , pp.551-582. Bartram, S., Brown, G., & Conrad, J. (2011). 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