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Financial derivatives and their role in risk management

Posted by Tasnim Ahmed

July 18, 2023    |     5-minute read (858 words)

Over the past few decades, market deregulation, growing international commerce, and ongoing technological advancements have completely transformed the financial marketplace. This transformation has led to increased market volatility, which in turn has resulted in a corresponding rise in demand for risk management products.

One financial instrument that businesses seeking refuge from the volatility of the financial markets are relying on is financial derivatives. Typically a financial contract between two parties, derivatives help allay various financial risk exposures that these firms may be exposed to. ·  

What are financial derivatives?

According to the IMF, financial derivatives are financial instruments that are tied to a particular financial instrument, indicator or commodity through which trading of particular financial risks in financial markets can be done.

They take many forms and are complex in nature. Its value is determined by the price of an underlying asset or index. No principal amount is provided in advance which must be paid back and there’s no accrued investment income, unlike debt instruments. Additionally, derivatives transactions ought to be handled separately rather than as critical components of the value of any underlying transaction to which they may be connected.

What is the importance of derivatives in risk management?

Derivatives play a crucial role in risk management by enabling investors to safeguard themselves against possible losses in the underlying assets. The practice of acquiring an offsetting position in a different market to balance out potential investment losses is known as hedging. There could be several risks, such as foreign exchange risks, interest rate risks, credit risks , and commodity price risks, for which derivatives can be used.

Derivatives provide a more structured capital allocation, ease international capital flows, and expand prospects for portfolio diversification by enabling investors to unbundle and transfer such risks. This shows how financial derivatives are vital for the growth of capital markets that function efficiently.

In some cases, derivatives can and have been utilized by market participants to deal with excessive risk, manipulate accounting standards and evade prudential safeguards. For instance, derivatives may enable a corporation to take on excessive leverage by moving some exposures off balance sheets if there is a lack of prudential supervision and an effective internal control system.

Understanding hedging through derivatives

Hedging through derivatives helps you mitigate the risks in a more efficient way. Listed below are a few ways in which derivatives could be used to hedge risks.

To hedge against foreign exchange, currency derivatives like currency forwards, futures and options can be used. Corporations with a wide network of operations spread across nations are more vulnerable to foreign exchange risk.

To hedge against interest rate risk, interest rate swaps could be used, which lets investors swap fixed interest rates for variable interest rates.

To hedge against commodity price risk, commodity futures and options can be used. With a futures contract, two parties can lock in a price on a future date to sell an asset. Whereas through an options contract, they can make an agreement to buy and sell an asset at a certain price at a certain time frame and without any compulsion for the buyer of the contract to use it.

To hedge against future price movements, you can take a position in a derivative whose value will rise in response to an increase in the price of the underlying asset and fall in response to a decline in that price. Despite the considerable risk involved, this tactic has the potential to offer huge profits. 

Besides, derivatives can also be used to increase leverage allowing an investor to control a larger portion of the underlying asset with a lower initial investment. This may boost the prospect of gains but also raise the risk of losses.

How are derivatives used by investors?

Derivatives aren’t typically employed as basic “buy-low-sell-high or buy-and-hold investments” because they come with a lot of complexities. Instead, the participants that are involved in a derivative transaction could employ the derivative to:

Hedge a financial position in the economy. 

A derivative can be used by an investor to hedge against future losses if they have concerns about where the value of a specific asset will go.

Speculate on the future price of an asset.

Investors can use derivatives to speculate on an asset’s prospective gains or losses if they anticipate a significant change in the value of the asset.

Efficient use of funds.

The majority of derivatives are margin-powered, so you might be able to invest in them with only a small amount of your funds. This can help when you are distributing funds in diverse investments to maximize returns while avoiding putting too much money in one area, whilst producing considerably higher returns than you would be able to with the cash you own. However, it also implies that if you choose poorly when placing a bet with a derivatives contract, you may be exposed to enormous losses.

The bottom line

Before you decide to make investments in derivatives, ensure that you have got the fundamentals of your finances in order as derivative investing is extremely risky, and putting a sizable chunk of your fund into it is not recommended.

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