Derivatives And Risk Management Essay Example | Topics and Well Written Essays - 2750 words

Derivatives And Risk Management - Essay Example Risk management is the process of identifying, understanding, analysing, accepting, or mitigating risk. Risk management can be divided into two main processes, determining the level of risk exposure in an investment and then handling that risk in the best way possible in line with the objectives of the investment (George, 2012, pp.34-38). The risk of financial exposure affects all organisations, both directly and indirectly. Though financial exposure presents the opportunity for loss, it may also present strategic benefits for making profits. The financial losses of a company arise from three main sources. The first source of risk is a company’s exposure to changes in the market prices of commodities (Philippe, 2001, pp.23-25). Second is through actions and transactions of third parties such as creditors and counterparties to derivative transactions, and finally are financial risks occurring from the internal failures of the organisation, people, or processes. Financial risk arises from countless transactions of a financial nature which an organization engages in such as purchases, investments, and loans repayments. If financial prices rise, there is the possibility that the company makes financial losses (Philippe, 2001, pp.3-6). ... Financial risk management usually involves the use of derivatives which are traded widely among financial market players. A derivative is a security whose price is derived from one or more other assets. It is just a contract between two parties specifying conditions under which payments will be made in future between the two parties. Examples of derivatives are options, futures, forwards, and swaps. In the past, diversification was the main way of financial risk management but has now been overrun by the availability of derivatives in most markets which makes it possible for both corporate as well as individual investors to manage risks (Whittaker, 2009, p.19). This paper will analyse the concept of hedging in financial risk management, the best hedging strategies, swaps, and options as they are used in risk management. 2.0 Hedging Vs. Speculation The management of risks involves the use of derivatives. Derivatives in financial risk management refer to securities whose value depends on the value of the underlying asset. Among the kinds of derivatives that exist in financial market includes futures, forward contracts, option, and swaps (Smith & Stulz, 2009, pp.267-284). The underlying assets whose values the derivatives depend on are stocks, bonds, interest rate, foreign exchange instruments, and even commodities. The respective derivatives for these assets are stock options, interest rates futures, currency futures, bond options, and commodity futures. Hedging is the strategy that is used when managing the risk of the underlying asset using derivatives (Nance, et al, 1993, pp.267-284). In financial markets, a hedge can be referred to as an investment position whose purpose is to offset a potential future