Risk Management Using Derivatives

People typically use derivatives for two reasons - either to increase leverage or to speculate on an asset's movement. But with proper planning and management, derivatives can be seen as a valuable tool for hedging or reducing existing exposure, as financial risks like Currency, Interest Rate, Default/ Credit Risk can be minimized by the help of derivatives. For doing this, it is essential to identify business risks accurately and to use the right control techniques, because derivative products can be used as insurances policies by paying premium. An Individual/Corporate may think that they can reduce their risk, but in case of event specific risk and unsystematic risk it’s not the same thing. Event specific risks can only be managed by buying insurance and unsystematic risks can be managed by diversification. In this article we'll discuss major financial risks and the way-out to use derivatives for managing those risks. Before going to the risk management, we have to understand some of the basic concepts of derivatives.

ARBITRAGE, SPECULATION and HEDGING

Speculation: - Betting on the future price of the assets & minimizing the investment amount by taking position in derivatives, is known as Speculation. The major role of speculator is to create liquidity in the market.
Arbitrage: -It is a practice of taking advantage of price difference in two different markets.
Hedging: - Controlling the risks of adverse price movement, by taking an investment position in the derivatives market, is known as hedging.

TYPES OF DERIVATIVES

Forward Over-the Counter
Option Over-the Counter , Exchange Traded
Swaps Over-the Counter
Future Exchange Traded

PRICING OF DERIVATIVES

As a Finance Controller of the company one should have a good understanding of all the factors that determines premium of the entire derivatives product, because premium is that amount that as a buyer you have to pay to the seller to protect the Company from the financial Risks.

Correct pricing of forward contracts and option premium, especially for the OTC product is really important as premium may vary person to person & counter to counter.

[This research article has already been published in FINANCIAL PLANNING JOURNAL by Mr. Gaurav Kumar Barick and has already been uploaded on Corporate Professionals Slideshare... }
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