The use of derivatives can be a great tool for institutions to increase profits or minimize risks. Nevertheless, the significant risks associated with derivatives suggests that derivatives must be actively managed. Derivatives can mitigate substantial losses should there be a significant increase or decrease in interest rates (Saunders & Cornett, 2011). In addition, these financial security instruments can help financial institutions to manage various types of risks (Saunders & Cornett, 2011). Furthermore, financial institutions can make use of various strategies to minimize the risks associated with derivatives making them optimal financial instruments if used and managed appropriately. In a study of a large number of non-financial firms, Bartram, Brown, and Conrad (2011) found that, in all, firms use derivatives to reduce risks because they are typically “more exposed to exchange rate risk (due to more foreign sales, foreign income, and foreign assets) and interest rate risk (due to higher leverage and lower quick ratios)” (p. 970). While their study does not speak directly to financial institutions, other authors suggest that financial firms also seek to minimize these types of risks with the use of derivatives (see Saunders & Cornett, 2011) suggesting a relationship between the two types of firms, at least in this regard. As such, the findings that firms can diminish various risks including cash flow, total, and systematic through the use of derivatives in financial management (Bartram et al., 2011) is likely to apply to financial firms as well. There are multiple strategies financial institutions can utilize to mitigate their risk using derivatives. Derivatives can be used to hedge losses resulting from fluctuations in... ... middle of paper ... ...xposure they are willing to accept, and how much they are willing to pay. After this has been completed, they can determine which strategy best aligns with their financial goals to ensure their risks and/or portfolios are appropriately hedged. Works Cited Bartram, S. M., Brown, G. W., & Conrad, J. (2011). The effects of derivatives on firm risk and value. Journal of Financial & Quantitative Analysis, 46(4), 967-999. http://dx.doi.org /10.1017/S0022109011000275 Basu, S. (2010). Insuring the investment portfolio. Journal of Financial Service Professionals, 64(6), 8-11. Retrieved from http://www.financialpro.org/index.cfm Bodie, Z., Kane, A., & Marcus, A. J. (2011). Investments. (9th ed.). New York, NY: McGraw-Hill/Irwin. Saunders, A., & Cornett, M. M. (2011). Financial institutions management: A risk management approach (7th ed.). New York, NY: McGraw-Hill/Irwin.
Money related derivatives empower companies to exchange particular monetary dangers, (for example, premium rate hazard, cash, value and product value hazard, and credit hazard, and so ...
Caterpillar Inc. also faces the risk of its cash flow and earnings being affected by fluctuations in the exchange rates of currency, commodity prices, and interest rates. To control for this, the company’s Risk Management Policy ensures prudent management of interest rates, commodity prices, and exchange rates of foreign currency by allowing the use of derivative financial instruments. According to the policy, the derivative financial instruments are not supposed to be used for the purpose of speculation. In its pricing strategy, Caterpillar Inc. faces the risk of difficult shipping of its products. This risk can be encountered by offering its products on instalments and lease to its loyal customers (Caterpillar, Inc. (CAT), 2011).
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Throughout financial markets worldwide the use of derivatives as a risk management methods have increased substantially over the last few decades. Derivatives are considered a financial instrument that derive their value from another financial asset or variable and as such they contrast from more commonly known financial instruments such as stocks and bonds. The main goal of derivatives is to protect investors against risk by allowing them to hedge their risk in the future value of an underlying asset (Derivative, 2016). This can be accomplished through different derivative forms, including swaps, options, forwards and futures. Forwards and futures are legally binding agreements used by investors
Finance theory does not provide a complete framework for explaining risk management under the fluctuated financial environment in which firm operates. Hence, for corporate managers, they rank risk management as one of their top priorities. One of the strategies to reduce risk is by hedging. This paper will discuss the advantages and disadvantages of hedging risk using financial derivatives.
Other types of exchange rate risks are translation risk and so-called hidden risk. The translation risk relates to cases where large multinational companies have subsidiaries in other countries. On the financial statement of the whole group, the company may have to translate the assets and liabilities from foreign accounts into the group statement. The translation will involve foreign exchange exposure. The term hidden risk evolves around the fact that all companies are subject to exchange rate risks, even if they don’t do business with companies using other currencies. A company that is buying supplies from a local manufacturer might be affected of fluctuating foreign exchange rates if the local manufacturer is doing business with overseas companies. If a manufacturer goes out of business, or experience heavy losses, it will affect all the companies it does business with. The co...
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After the financial crisis of the late 1990s, the demands for risk management tools have increased. The investors have been effectively utilizing such products as KOSPI 200 futures and options, 3-Year KTB futures and USD futures to meet their hedging needs.
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Banks like JPMorgan and UBS have experienced the cost of what happens when you go into derivative trading. The derivatives market is extremely complex and not transparent. Since most of the trading is done over the counter, it is difficult to determine the actual value of the market. The entire market is supported by a small amount of cash, so if it were to crash the losses could add up to more money than the world has. The financial crisis should have been a warning to reduce the use of derivatives but instead it has grown. With that in mind, derivatives can be seen as time bombs. It’s only a matter of time before the next financial crisis happens at the cause of derivatives.
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.