Use of Financial Derivatives in Managing Corporate Risk Finance Essay

Financial derivatives are instruments whose value is derived from one or more underlying financial asset. The underlying instrument could be a financial security, a securities index, or some combination of securities, indexes, and commodities. It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. Derivatives are broadly categorized as: Relationship between the underlying and the derivative (e.g., forward, option, swap). Type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives). Market in which they trade (e.g., exchange-traded or over-the-counter) Pay-off profile. Derivatives are used by Investors because it: Provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative. Speculate and to make a profit if the value of the underlying asset moves the way they expect. Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out.

HISTORY AND EVOLUTION OF DERIVATIVES

Innovations in financial theory and increased computerization, along with changes in the foreign exchange markets, the credit markets and the capital markets over this period, have contributed to the growth of financial derivatives. The first exchange-traded financial derivatives emerged in response to the collapse of the Bretton Woods system of exchange rates established in 1944. Under this system, most governments agreed to fix the exchange rate of their currencies relative to the U.S. dollar, which was convertible into gold. In 1971, the U.S. Treasury abandoned the gold standard for the dollar, causing the breakdown of the fixed-exchange system, which was replaced by a floating-rate exchange system. The need to hedge against adverse exchange-rate movements provided an impetus for currency futures to emerge. Foreign currency futures were introduced in 1972 at the Chicago Mercantile Exchange ("Mere"). In 1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitate the trade of options on selected stocks.

TYPES OF DERIVATIVES:

OTC and exchange-traded:

OTC and exchange traded contracts that are traded directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. According to the Bank for International Settlements, the total outstanding notional amount is $684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% is equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform.

Exchange-traded derivative contract:

ET's are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individual's trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges.

Common type of Derivatives:

FUTURE FORWARD: are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves. Let K-delivery price, and T-maturity, then a forward contract's payoff VT at maturity is: VT = ST - K, (long position) VT = K - ST, (short position) Where ST denotes the price of the underlying asset at maturity t = T. OPTIONS: Options are the contract that give owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.

Mathematical Modeling and Methods of Option Pricing

USD in cash return = 730,000 - 666,000 100% = 9.6%; 666 000 Strategy B. The investor exercises the option to receive a payoff: Payoff = 730,000 - 680,000 = 50000USD Return = 50,000 - 39,000 39,000 X 100% = 28.2%. Situation I1 The stock goes down to 66,O USD on August 22. Strategy A. The investor suffers a loss: loss = 666 000 - 660 000 = 6000USD, Strategy B. The investor receives a payoff: payoff = (660 000 - 680 000)+ = 0. The investor loses the entire invested 39, 000 USD, hence a loss of 100%. SWAPS are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

ARBITRAGEUR:

Arbitrage: Arbitrage based on observations of the same kind of risky assets, taking advantage of the price differences between markets, the arbitrageur trades simultaneously at different markets to gain riskless instant profits. Arbitrage is not the same as speculation: speculation is to seek profits promised by predictions of the future prices, and is thus risky. Arbitrage is to snatch profits originated in the reality of the price differences between markets, and is therefore riskless. An opportunity for arbitrage cannot last long. Since once an opportunity for arbitrage arises, the market prices will soon reach a new balance due to actions of the arbitrageurs and the opportunity will thus disappear.

VALUATION OF DERIVATIVE:

Market price: The price at which traders are willing to buy or sell the contract. Market price can be determined as for exchange-traded derivatives, market price is usually transparent. Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices. Arbitrage- free price: Under this method no risk- free profits can be made by trading in these contracts means rational pricing. The Arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider.. A key equation for the theoretical valuation of options is the Black- Scholars formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model.

APPLICABILITY OF FINANCIAL DERIVATIVE:

STRATEGIC APPLICATION IN 1203: In the past twenty years international financial markets have been subject toward -reaching structural changes often describe"deregulation, Seccuritization, computerization and globalization". National controls of the capital markets were reduced, making a free world-wide flow of capital possible. Factors arising from the above named rapid changes were an increased volatility and sensitivity of interest and exchange rates, as well as the growing competition especially within the insurance sector. Financial innovations can be used to manage risk and equally used to make profit. In view of the changes taking place in the financial markets, the insurance sector is forced to restructure their investment strategies. Growing demands for better services from the consumer side also compel insurance companies to take action towards improving their all-round performance and thus sustain in the competitive markets .In the past financial derivatives have been applied extremely hesitantly insurance companies. One reason for this is the relatively restrictive legal basis created by the Federal Insurance Provisory Office. Since 1991 the Federal Insurance Provisory Office has put down new legal regulations determining the use of derivatives in the insurance business. STRAGIC APPLICABILITY OF FINANCIAL DERIVATIVES IN  1205: Principle of Safety: The main criterion of capital investments by any insurance company is the safety of these investments. This safety is not only to be ensured at the time of the investment but also for its entire duration. Regular control of the assets and the debtors are absolutely necessary.

Principle of Profitability: The profitability of an asset is featured by the yield to be gained, while simultaneously meeting requirements of safety and liquidity in certain making situation. The profitability of assets is also used to compensate for losses made due to events of damage. Principle of Liquidity: Incoming and outgoing payment streams (premiums etc.) vary from one Insurance area to another. In the life-insurance sector payment streams are relatively regular, whereas payment streams in other sectors can be subject to higher fluctuations derived from coincidental and irregular damage that occurs. Therefore demands put to the management of liquidity differ. This also influences the structure of a portfolio which can have different levels of liquidity, depending on the type of insurance cover that is offered. Principle of Mixture: Mixture is meant in the sense of evaluating the individual assets of an entire portfolio according to the specific risk inherent in shares, bonds and options. By mixing the assets, risk-momentum of each portfolio can be minimized. STRATEGIC APPLICATION OF FINANCIAL DERIVATIVES IN . . . 1209: Transformation of national and international financial markets. A sharp acceleration in the pace of innovation, deregulation and structural change in recent years has transformed the international financial system. Financial markets have become far more closely integrated world-wide; capital has become much more mobile. Increased complexity of financial transactions, as well as the higher volatility of interest rates and prices make risk- and interest rate management an absolute necessity.

The idea of all-round financial services. The attractiveness of the insurance market encourages further insurance agencies , banks and building societies to enter the market. As a result of this, markets, formerly reserved to the insurance branch only or the banking branch exclusively, began to overlap, thus breaking down existing market eliminations , depriving insurances of their traditional business area and forcing them to increase their offer of financial services in order to keep their position in the market. Process of concentration: New demands put to the insurance business by the market itself and the insurance customers will give rise to intensified investments in marketing, new products, target-groups and cost-management. AU in all, not every insurance corporation will be able to keep up with the new standards, so smaller companies will withdraw from the market; others will have to specialize on certain products. STRATEGIC APPLICATION OF FINANCIAL DERIVATIVES IN . . . 1211: Product-innovations will head in the direction of designing products that maximize the fulfillment of the needs of the clients. Alterations in investment strategies of insurance companies Decisions concerning the structure of capital investments of insurance companies are made on the basis of foreign exchange, interest rate and profit prognosis. Investments today are exposed to the following risks: Economic risk = recession -risk of inflation -interest rate and price risk -political risks; national and international -credit risk of debtors Taking these risks into account, decisions to buy, hold or sell are made. Risk management will become one of the most important tools of capital investment strategies. Modem risk management consists of: -regular evaluation of each business transaction -determination of factors that influence investment positions -analysis of cash flows and sensitivities -quantification and management of risk -setting of limits

TYPES OF RISK:

Market Risk Credit Risk Liquidity Risk Operational Risk Enterprise Risk Systemic Risk Individual derivative Risk Risk profile Dynamic Hedging Delta, Gamma and Vega Hedging Exotic Derivative Risks.

CORPORATE RISK:

RISK: Risk is the uncertainty of the outcome. Risk can bring unexpected gains. It can also cause unforeseen losses, even catastrophes .Risks are common and inherent in the financial markets and commodity markets: asset risk, interest rate risk, foreign exchange risk, credit risk, commodity risk and so on. There is different attitude towards risk: 1.RISK AVERSION : Quantify an identified risk and control it, i.e., to devise a plan to manage the exposed risk and convert it into a desired form. 2. RISK SEEKING: Willing to take the risk with one's money, in hope of reaping risk profits from investments in risky assets out of their frequent price changes. Acting in hope of reaping risk profits from the market price changes is called speculation.

CONCLUSION:

Financial derivatives are used to reduce risk involved in investment. Various derivative tools such as Future, Forward, Hedging, Swaps, and Option are used to control risk. Financial derivatives have grown rapidly in recent years due to improvements in computer technology, innovations in financial theory, and the need to manage risks arising from volatility in the interest and currency exchange rates. Derivatives are increasingly being used to manage various kinds of risk exposure, to obtain desirable financing, and to enhance investment and speculative opportunities. The complexities of the derivatives markets are increasing every day, and it is important for the policy makers and regulators to understand these markets before hastily adopting any major legislative or regulatory changes.

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