30-06-2012, 04:12 PM
Derivatives as a Risk Management Tool
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The financial environment today has more risks than earlier. Successful business firms are
those that are able to manage these risks effectively. Due to changes in the macroeconomic
structures and increasing internationalization of businesses, there has been a dramatic increase
in the volatility of economic variables such as interest rates, exchange rates, commodity prices
etc. Firms that monitor their risks carefully and manage their risks with judicious policies enjoy
a more stable business than those who are unable to identify and manage their risks.
There are many risks which are influenced by factors external to the business and therefore
suitable mechanisms to manage and reduce such risks need to be adopted. One of the modern
day solutions to manage financial risks is ‘hedging’. Before trying to understand hedging as a
risk management tool, we need to have a proper understanding of the term ‘risk’ and the
various types of risks faced by firms.
What is risk?
Risk, in simple terms, may be defined as the uncertainty of returns. Risks arise because of a
number of factors, but can be broadly classified into two categories: as business risks and
financial risks.
Business risks include strategic risk, macroeconomic risk, competition risk and technological
innovation risk. Managers should be capable of identifying such risks, adapt ing themselves to
the new environment and maintaining their competitive advantage.
Financial risk, on the other hand, is caused due to financial market activities and includes
liquidity risk and credit risk.
The role of financial institutions is to set up mechanisms by which firms can devolve the
financial risks to the institutions meant for this purpose and thereby concentrate on managing
their business risks. Financial institutions float various financial instruments and set up
appropriate mechanisms to help businesses manage their financial risks. They help businesses
through:
· Lending/ Borrowing of cash to enable the firms to adjust their future cash flows.
· Serving as avenues for savings and investments, helping individuals and firms in
accumulating wealth and also earn a return on their investment.
· Providing insurance, which protects against operational risks such as natural
disasters, terrorist attacks etc.
· Providing means for hedging for the risk-averse who want to reduce their risks
against any future uncertainty.
Risk Management
An effective manager should be aware of the various financial instruments available in the
market for managing financial risks. There are many tools for the same and a judicious mix of
various tools helps in efficient risk management.
Since the early 1970s, the world has witnessed dramatic increases in the volatility of interest
rates, exchange rates and commodity prices. This is fuelled by increasing internationalization of
trade and integration of the world economy, largely due to technological innovations. The risks
arising out of this internationalization are significant. They have the capacity to make or break
not only businesses but also the economies of nations. However, financial institutions are now
equipped with tools and techniques that can be used to measure and manage such financial
risks. The most powerful instruments among them are derivatives. Derivatives are financial
instruments that are used as risk management tools. They help in transferring risk
from the risk averse to the risk taker.
In this module, we concentrate mainly on the exchange rate risks and their management. We
shall know more about these instruments and how they help mitigate exchange rate risks in the
later chapters.
Types of Traders in the Derivatives Markets
One of the reasons for the success of financial markets is the presence of different types of
traders who add a great deal of liquidity to the market. Suppliers of liquidity provide an
opportunity for others to trade, at a price. The traders in the derivatives markets are classified
into three broad types, viz. hedgers, speculators and arbitrageurs, depending on the purpose
for which the parties enter into the contracts.
Hedgers
Hedgers trade with an objective to minimize the risk in trading or holding the underlying
securities. Hedgers willingly bear some costs in order to achieve protection against unfavorable
price changes.
Speculators
Speculators use derivatives to bet on the future direction of the markets. They take calculated
risks but the objective is to gain when the prices move as per their expectation. Based on the
duration for which speculators hold a position they are further be classified as scalpers (very
short time, may be defined in minutes), day traders (one trading day) and position traders (for
a long period may be a week, a month or a year).
Arbitrageurs
Arbitrageurs try to make risk-less profit by simultaneously entering into transactions in two or
more markets or two or more contracts. They profit from market inefficiencies by making
simultaneous trades that offset each other thereby making their positions risk-free. For
example, they try to benefit from difference in currency rates in two different markets. They
also try to profit from taking a position in the cash market and the futures market.