Use of Derivatives in Risk Management - Research Paper Example

? and Number of Paper: Use of derivatives in risk management Submitted Use of derivative in the Risk Management Introduction For any corporation, risk management is of prime importance. In today’s dynamic global economy, every company is looking for and devising ways through which it can curtail the element of risk in its operations and function smoothly without any hindrance. Derivatives are considered to be the modern age tool when it comes to risk aversion. However, there are few critics who consider derivatives harmful for the financial outlook of a company and for the economy in general. The main reason for such criticism is the lack of understanding of the derivatives transactions. This paper elaborates on the risk management process of risk management and evaluates how derivatives assist in managing the risk. Introduction to risk management Risk, in most general terms can be defined as the probability of loss. (investopedia, 2012) An organization usually faces risk when it has exposed itself to a certain transaction in which there is a possibility of loss. In this dynamic and modern era, almost all organizations are dealing in and exposed to the financial markets, whether domestic or international. The global economic environment and the financial market have evolved drastically over the past decade. With the advent of information technology at a rapid pace, the financial markets of the world are now closely integrated. Due to this phenomenon of the world being a global village, a turbulence originated in a far distant financial market can have eventual consequences all across the globe. With the revolution in the communication technology, the access to information is instantaneous and thus the subsequent market reactions. In this dynamic world of today, it is of prime importance to understand the concept that how does financial risk arises in order to safeguard’s one asset from deteriorating while being exposed to such risks. For any organization or a company, the financial risk arises by entering into a financial transaction such as sales, purchase, investing into securities and bonds, sanctioning of loan and advances, mergers and acquisition transactions, debt financing etc. Financial risk is directly co-related to the prevailing financial prices in the markets, as the fluctuation in these prices causes an increase in the cost to the companies, reduction in the revenues and thus adverse impact on the profitability of the company. These underlying financial prices can be anything ranging from the market interest rates, exchange rates and commodity prices. Other aspects which yield financial risk in the transactions are dealing in derivatives and internal failures of the process and people of any organization. The financial risk management process mainly copes with the uncertainties resulting from the financial market. The first and foremost step in this process is to identify the current exposure of the company and devise strategies accordingly keeping into consideration the priorities of the company. It depends upon the proactive decision making and the decisiveness of the company on how to cope with the current exposure of the company. In general, companies do realize that avoiding all risk is not possible in order to operate and thus they end up accepting a considerable amount of risk. Risk management is considered to be an ongoing process as the strategies needs to be updated and refined keeping into consideration the market norms and requirements. These changes are primarily brought about by the changes in the expectation about the market rates, business norms and practices and the international financial scenario. The most common strategy practiced by the companies all across the global financial market is to curtail their exposure to risk through the use of derivatives. Risk Management Process Risk management process is a continuous and iterative process which requires analysis of both internal and external risk factors. The process guides and enables an organization to identify and manage the risks associated with the financial markets. An analysis of the companies all across the globe (which are actively involved in the risk management activities) would present the fact the risk management process is quite dynamic and starts with the business and its operating structure. The risk management process is not confined with a single department of the company, but the process also expands to other departments such as treasury, commodity sales, corporate finance etc. The first and foremost process of the risk management is the identification of and prioritization of the risk to which the company is exposed to. For this step, it is quite essential for the company to have a clear knowledge of the various variables such the products it is dealing in, its internal and external stakeholders, shareholders, suppliers, industry norms and regulations, financial outlook and competitors in the market. Companies most importantly consider the level of risk that their shareholders are willing to tolerate. After obtaining a clear understanding of all the risks to which the company is exposed to, appropriate strategies are devised by the companies keeping into consideration the risk management policies of the companies. An example of the risk management strategy would be to diversify the operations of the entity by expanding the product line for entity. In order to understand this example, consider a company whose is primary business dealing in petroleum products. This particular company would be exposed to the risk of the fluctuation in the oil prices in the international commodity market. Keeping it into consideration, the prudent risk management tactic for the company would be to diversify its operations a bit by started dealing in other commodities as well. For any financial institution, the primary and most commonly used hedging strategy is the use of derivative instruments. The management of exposure to risk assists the decision makers in the organization in taking crucial and essential decisions. Since the risk management process is an iterative and ongoing process, the regular feedback can be used in order to refine the operational strategies of the company. Introduction of Derivatives In today’s financial market derivatives are the most prudent and effective method of hedging. Derivative is basically a financial instrument that offers a return based on the return of another underlying asset. From financial management point of view, derivatives contract can be divided into two general categories forward contract and contingent claims. The forward contract is an agreement between two parties in which one party, which is termed as the buyer, agrees to buy from the counterparty, seller , an underlying asset at a predetermined price (usually agreed at the start of the contract). This transaction takes place at a certain date in the future. The forward transactions are quite common in today’s financial market and banking firms, governments and corporations are actively involved hedging their assets and exposures through the use of forward contracts. There are two variations in the forward contract which are the future contracts and the swaps. Both of these types of derivatives are very effective when it comes to the curtailing of risk in the financial market. The other category of the derivative contract is the contingent claims. In contingent claims type of derivatives contract, the pay off occur if a specific future event, as mentioned in the contract, takes place. Following is the list of the most common derivative used in the global financial market Exposure Derivatives Used Exchange rate exposure Forward Contracts, Future Contracts, Foreign Currency Swaps and Options Interest rate Exposure Interest rate swaps and options Commodity rate change exposure Cash Flow Hedges and Commodity Swaps (Nobile J, 2007) Use of Derivative for risk management When a multinational operates in a number of markets, internationally, it is exposed to a great deal of risks, and in order to operate as per its predetermined objectives, the management of these risks is of prime importance. These risks pose a direct threat to the assets, liabilities and operative income of the firm which commonly results from the variations in interest rates, exchange rates and inflation rates. Macroeconomic environment of different countries plays an important role in setting up these risks which affect different countries according to their structure. For example a multinational which is heavily involved in the import and export business is likely to get affected significantly due to the fluctuation in both the exchange rate and inflation rate of the country it is transacting with, whereas, a multinational having a foreign subsidiary is not likely to be affected by the change in the exchange rate. The global operations of any multinational require it to actively participate in international trade which causes it to be exposed to a great deal of foreign exchange risks. These companies engages in international trade through foreign exchange forward contracts and options and cross currency swaps to hedge various currency exposures. These exposures primarily include assets, liabilities and bonds denominated in foreign currency. Effective financial management requires identification of risks and taking effective measures in order to curb them. This requires evaluating the exposure of the multinational company and the corresponding risk. International exposure of the multinational companies can be defined as the value of its assets and liabilities, presented in its functional (primary) currency, exposed to the change in the foreign interest rates, exchange rates and inflation rates. The foreign risk exposure can be classified into two broad categories. Transaction Exposure; and Translation Exposure Exchange rate can be defined as the relative price of one currency in terms of other. The exchange rate plays a very significant role in determining the capital flows and investments between international boundaries. In order to exercise prudent financial management, it is of prime importance for the multinationals to forecast the future exchange rates so that they do not suffered exchange losses and incur additional liability. Multinational companies, in order to curb the foreign exchange risk exposure enter into hedging transaction which means reducing or controlling risk. In hedging transaction, the firm take place a position in the future market which is opposite to the one being taken in the spot market. The underlying objective of the hedging is to reduce or limit the risk associated with the change in the exchange rate. For example, if an American company has an obligation to pay ?100 in month time and currently the exchange rate parity between USA and UK is ?1 is equal to $1.5, currently in its principal currency, $, the American company has the obligation of paying $150. Now if the financial managers of the American company forecast that the exchange rate parity between USA and UK will be ?1 to $2, then the company will be liable to pay $200 and thus will have to pay $50 more due to the fluctuation in exchange rate. In order to cater this situation, the company can enter into a hedging transaction whereby it enters into a transaction where it has to receive ?100 in one month, so that the loss on payable is offset by the gain on receivables. There are several types of foreign currency risk hedging. The most common types of foreign currency hedges that can be observed are the foreign currency forward contracts and foreign currency options. In forward contracts, the settlement of the transaction is contracted at a rate which is decided beforehand at a rate which is termed as the forward rate. (Accounting tools, 2012) On the other hand, in foreign currency options, the owner has the right to buy or sell a particular amount of the currency at a rate which is predetermined on the purchase date. There is no obligation in the case of foreign currency options, whereas the forward foreign currency contracts are binding. Other forms of hedges are money market hedge and foreign currency swaps. In addition to the above mentioned, multinationals can also be exposed to interest rate risk which arises due to the fluctuations in the underlying interest rate in the economy to which the assets and liabilities of the companies are exposed to. These companies tend to borrow and lend and in international capital markets based on which the uncertainty in the fluctuation in the interest rate also poses a threat to the profitability. Uncertain exposure in the interest rate affects both the income and expense on the financial asset and liability of the company. Effective management of financial affairs requires that the multinationals identify its exposure to the fluctuation in the interest rate and then set comprehensive guidelines for monitoring key parameters. These objectives might include monitoring the net interest income of the company (total interest income minus total interest expense). This close monitoring also assists the company in identifying the sensitivity of the firms profit to the change in the interest rates. Prudent risk managers also keep into consideration the effect of the fluctuation of the interest rates to the net worth of the company. Interest rate hedging can be done through several ways which includes forward rate agreements, future contracts, swaps and interest rate options. Derivatives can be regarded as the most commonly used method when it comes to risk aversion and avoidance techniques. In financial terminology, hedge, created by a derivative, can be defined as an investment position the primary reason of which is to offset probable losses arising from a related investment position. In general terms, the analogy of hedging can be made with insurance. In insurance people safeguard themselves against a loss that can take place due to any uncertain event that is liable to take place in the future. Although insurance does not averse the risk from taking place, it assists in curtailing the impact of it. In the dynamic financial world of today, hedging is practiced by investment bankers, portfolio managers, individual investors and other corporations. From the look of it, hedging can appear to be quite a simple transaction, but in reality it is quite a complex arrangement. The primary reason for using hedging is to guard against the adverse price movement in the financial markets through the use of instruments. Criticism of Derivatives Derivatives have remained highly controversial for a majority of reasons. The first argument that the economist and the financial analyst present against these transactions is that they are very complex and difficult to understand. The main reason behind such criticism is basically the failure of the investors and risk takers in grasping the methodology of these transactions. When a derivative transaction fails, the investors are blamed for it rather than the investor himself. Derivatives are often used improperly in the financial market which can lead to potentially large losses. In addition, various critics of derivatives have also labeled use of these financial instruments as being indulging one in gambling. (investopedia, 1967) These critics fail to understand the fact that the benefits of derivatives in the risk management are far reaching and pervasive in the society. By providing a means of managing risk along with other substantial benefits, the derivatives also make financial market works better. Conclusion As apparent from the above explanations, the derivatives are quite useful and efficient in the risk management. Most of the losses that are attributed to the derivatives are basically the mistakes and lack of judgment on part of the hedger/investor. If the underlying methodology of a derivative transaction in properly understood and an adequate grasp of its functionality in the financial market is acquired, the positive and beneficial effects of it can be witnessed. References Accountingtools.com (2012). Forward Exchange Contract - AccountingTools. [online] Retrieved from: http://www.accountingtools.com/forward-exchange-contract [Accessed: 26 Oct 2012]. Investopedia.com (2012). Risk Definition | Investopedia. [online] Retrieved from: http://www.investopedia.com/terms/r/risk.asp [Accessed: 26 Oct 2012]. Investopedia.com (1967). CFA Level 1 Study Guide - Derivatives - Criticisms of Derivatives | Investopedia. [online] Retrieved from: http://www.investopedia.com/exam-guide/cfa-level-1/derivatives/criticisms-derivatives.asp [Accessed: 26 Oct 2012]. Nobile, J. (2007). Types of Foreign Currency Hedging Vehicles. [online] Retrieved from: http://ezinearticles.com/?Types-of-Foreign-Currency-Hedging-Vehicles&id=33053 [Accessed: 26 Oct 2012]. Read More