Companies deal with a variety of risks in their daily operations in the connected and unpredictable global financial market of today, including credit, liquidity, and operational risk. These risks could have a negative influence on the organization’s sustainability and profitability if they are not adequately addressed. As a result, risk management becomes an essential strategy for maintaining stability and safeguarding investors.
However, let’s define derivatives first.
What are Derivatives?
Derivatives are financial instruments whose values are determined by the underlying asset. It is a fairly complex financial instrument that contracting parties use to mitigate risk or provide security against any uncertain event. The most prominent types of derivatives are futures, forwards, options, and swaps which can be used to manage risks and ensure buying or selling commodities at a fixed price in the future, regardless of price fluctuations, interest rate changes, or currency volatility.
Risk Management and Hedging
Risk management is the process of identifying, assessing, and mitigating both present and emerging threats that could significantly impact their financial, operational, and strategic objectives. After the identification and assessment of the risks, they can be tackled with strategies like hedging, diversification of assets, margin management, and regular monitoring.
Hedging
Hedging is a risk management strategy that involves buying and selling financial investments to reduce the potential loss in a current position. To understand it better, suppose an investor owns a stock in a company. So, to manage the risk he purchases a put option as a hedging strategy.
Now, if the share price decreases, the investor can sell the share at a predetermined higher price and if the share price increases in the future, he can let the put option expire and incur only the loss of the premium.
Hence, this strategy allowed the investor to limit downside risk while still participating in potential upside movement.
After understanding risk management and hedging, here are some of the ways of how derivatives can be used to mitigate risks.
Derivative Strategies to Reduce Risks
Derivative products provide investors and financial managers with cutting-edge risk management tools that may be used to hedge and mitigate against both basic and complex risk exposures. Here are the 3 ways you can use to reduce risks:
Market Risk Hedging
Market risk refers to the risk of losses arising from unfavorable changes in the market variables such as commodity prices, stock prices, interest rates, and currency volatility. Investors and companies with significant market risk exposure can hedge the risk by taking offsetting positions in derivatives markets. Short selling, covered calls, and asset allocation are some techniques for market risk hedging.
We can see this strategy in the agriculture industry (farmers can enter into a futures contract to protect themselves from a potential decline in crops’ prices), the financial services industry (banks use interest rate swaps for hedging against the rise of interest rates), and also in manufacturing industry (manufactures can use future or options contract to lock in the prices for their raw materials or foreign exchange needs).
Liquidity Risk Management (LRM)
With the help of derivatives, financial institutions can manage the liquidity risks better. Interest rate swaps and index swaps can be used to meet short-term needs and to maintain sufficient cash flows. Other than swaps, futures and options can also be used to provide liquidity to their contracts. Because of this property, it is easier for investors to enter and exit the derivative market.
Some of the popular practices related to LRM are cash flow forecasting, liquidity risk assessment, and diversification of funding sources.
Liquidity risk management is used in the banking industry, manufacturing industry, and industries like real estate.
Credit Risk Mitigation
This uses the concept of “transfer of risk” in which one party pays another to take responsibility for mitigating specific losses that may or may not occur. By transferring credit risk to others, lenders can undertake more lending activity than would be possible without offloading the risk. Some of the credit risk mitigation techniques include collateral, credit derivatives (credit default swaps), and credit scoring.
Credit risk mitigation is prominently seen in the banking industry (banks use credit scoring and collateral), trade and export industry (credit derivatives are used), and the energy industry.
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Advantages and Disadvantages of Derivatives in Risk Management
Derivatives being a popular financial instrument have its own advantages and disadvantages. Let’s have a closer look at both the pros and cons.
Advantages
Derivatives are a great financial instrument for investors to identify risk and determine the different strategies to mitigate potential losses arising from market fluctuations. However, there are more advantages to them.
- Derivatives help in determining the correct price of the commodity resulting in maximum profits for the investors. Along with this, derivatives are used to transfer risk to reduce specific losses that may not occur.
- One of the many reasons derivatives are widely employed as financial tools is their operational efficiency. This feature states that derivatives are thought to be cost-effective because they make it easier to take positions in the market and reduce the transaction costs involved, which increases market efficiency.
- The derivative instruments have perfect liquidity as there are multiple participants like hedgers, speculators, and arbitrageurs. This characteristic of liquidity lowers transaction costs and facilitates the settlement of open contracts, giving investors greater flexibility to buy and sell assets as needed.
Disadvantages
After discussing the advantages, now let’s look at the drawbacks of this popular financial instrument.
- Derivatives are highly speculative due to which it has also been associated with gambling. This is because of speculation; the markets have become more volatile which increases the risk in the market.
- Without proper knowledge of the financial instruments and the assets, derivatives can lead to many financial losses for the speculator. They cause destabilization of financial markets and increase the associated risk of dealing in financial instruments.
- Furthermore, because derivatives are highly leveraged financial products, there is a chance that they would default, which might set off a chain reaction of defaults in the financial markets that could bring down the entire economy.
Conclusion
For businesses and investors, derivatives are useful for a variety of risk management strategies. As part of a comprehensive risk management plan, using futures, options, swaps, and other derivative instruments appropriately can assist regulate and minimize the impact of various risk exposures. Derivatives do, however, carry additional risks, including counterparty risks, complexity, and valuation difficulties. Therefore, it is vital for companies employing derivatives hedging strategies to also focus on managing the associated derivative risks.
