Derivatives in Risk Management
One of the uses for derivative products is in risk management. Organizations have recognized that derivatives can be used to manage risk by offering guaranteed outcomes for a set up-front cost. For firms that face risk due to fluctuations in asset prices -- typically commodities or currencies -- beyond their control, derivatives represent a means of achieving cash flow certainty, if not profit certainty. This paper will explore the different forms that derivatives take, and the different ways in which they are used as a risk management tool. Some recommendation will be given with respect to the use of derivatives in risk management in order to optimize results.
Derivatives and Risk Management
In finance, a derivative instrument is one that has a price that is based on the price of a real underlying asset -- agricultural commodities, metals, sources of energy, currencies, stocks and bonds (Chance & Brooks, 2008). Each of these assets is subject to market price fluctuations. While theoretically at least these fluctuations reflect the intrinsic value of the good on the world market, mathematically they are random, reflecting the "divergent anticipations and conflicting interests" that render them unpredictable (Bouchard & Potters, 2003). When an organization has a financial stake in the value of an underlying asset, the unpredictable fluctuation of the value of that asset can be detrimental to other elements of the normal conduct of business. For example, profitability can be affected by changes in the value of foreign currencies between the sale of a good and the receipt of payment for that. Pricing strategy is also affected.
A classic example is in the airline industry, where competition is intense and consequently margins are razor-thin. Fuel prices are roughly a third of the cost structure of airlines, and they are highly volatile. When airlines set ticket prices in line with the competitive dynamic of the day, they are also taking into consideration the expected future fuel price, ensuring that the ticket price they set allows them to operate the flight profitably. Fluctuations in fuel prices can remove profitability from that flight, especially given the thin margins and high volatility of fuel prices (Snyder, 2011).
The use of derivatives as a risk management tool reflects the use of derivatives to lock in the value of future cash flows today. Bodnar, Marston and Hayt (1998) found that half of all businesses use derivatives to manage risk, and 68% of primary product firms did so. Firms tended most frequently to hedge their foreign currency exposure. Most firms, however, only hedged a portion of their foreign currency exposure, and only for the short-run of less than 90 days (Ibid). Most firms reported being concerned about counterparty risk on longer derivatives, influencing their decision to only hedge short-run exposures. Hedging refers to the practice of using derivatives to lock in the value of future cash flows (i.e. risk management). In addition to currencies, companies hedge interest rate risk, commodity prices and to a lesser extent equities.
There are a number of methods by which organizations can use derivatives for risk management. Futures, calls and puts are all traded publicly on exchanges, facilitating basic risk management using pre-set amounts. While it is difficult to get a perfect hedge using publicly-traded derivatives, few firms seek a complete and perfect hedge anyway. There is also significant benefit to using market-based risk management because of the inherent liquidity and transparency of derivatives markets. Methods such as swaps, forwards and more advanced, structured forms of risk management may lack liquidity and transparency, but are possible through the use of intermediaries, typically the company's bank. Any option has a transaction cost that represents the primary opportunity cost of the technique. Further, there is usually some degree of counterparty risk, that the other party in the deal will be unable to fulfill its part of the bargain. Typically, this leads to major banks as counterparties, rather than smaller banks or other corporate entities.
Locking in future cash flows carries with it some risk of its own. The unpredictable nature of price fluctuations in market-based assets means that a company is as likely to "win" as it is to "lose" on a hedging transaction. For example, if an airline buys futures to hedge fuel prices, and the price goes up, the airline will win because the price it paid will be less than the market price at the time of purchase. However, if the price goes down, as in the second half of 2008, the airline will book a significant loss (Rivers, 2012). The...
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