Risk Financial Management: Understanding Derivatives

Overview

Derivatives are becoming a common problem today in the financial and banking sectors. Huge gains or losses may be attained when these financial instruments are finally settled in the future. Though it is used to minimize risk, trading in derivatives has oftentimes been considered as high risk, more so if entities are highly exposed to it.

If risky, why go into it?

Banks as well as financing institution go into financial instruments like derivatives to manage their risk. These risks are brought about by foreign currency fluctuations, changes in commodity prices, and fluctuation in cash positions.

The need to decrease probable financial losses, are the main reasons why these institutions trade in derivatives.

What specifically are the risks that these companies would want to avoid?

• Credit risk – the financial institution’s exposure to loans and credit, gives it the uncertainty of a possible non-payment by borrowers;

• Fluctuating interest rate – changes in interest rates would greatly affect the entity’s cash flow situation.

• Foreign currency risk adjustment – uncertainty about the country’s future cash flow resulting from the local currency being denominated in U.S.Dollars.

What then, is a Derivative?

A derivative is a financial instrument whose values is derived from the probable movements of foreign exchange rates, commodity prices, and interest rates. It is an executory contract between two parties or an exchange of promise to be made at some future time. In simple terms, what this means is that two parties are taking bets on what will happen on the financial instrument at some specified time.

How do you know what a derivative is?

• The value of the derivative fluctuates with changes in the underlying variation on which it is based – foreign currency, interest rates, and commodity prices;

• There is no payment for the instrument at the time of contract;

• The derivative is settled at some future time with a net cash payment.

Underlying concept in derivatives…

Hedging – derivatives are mostly used for hedging purposes. It is the act of protecting a probable financial loss and to reduce risk.

Two components of a hedge

• Hedging instrument – is the derivative whose fair value is expected to offset changes in fair values of the hedged assets.

• Hedged items – consist of items that are exposed to risk as a result of possible changes in cash flows. These would include: asset, liability, commitment contracts, and net investments in foreign operations.

Measuring the values of derivatives:

• Entities shall booked derivative instruments at its fair market value;

• Gain or loss is recognized when there is a change in fair market values;

• To recognize whether there is a profit or loss, would depend on the following factors:

a. No hedging designation – if not designated, the instrument shall be recognized as mere speculation; hence, changes in values should be recognized;

b. Derivative considered as a cash flow hedge – a derivative that offsets probable changes in cash flow resulting from expected transactions. These transactions, though uncommitted, are expected to occur at some future time.

c. Fair value hedge – the financial instrument is measured in terms of adjusted fair market values; where changes in valuation are recognized as either a profit or a loss.

Common Examples of Derivatives

The derivatives that are oftentimes considered as hedging instruments by banks and financial institutions are the following:

• Interest rate swap – the contract loan is considered as the primary financial instrument; the interest rate is the derivative. The interest payment is based on the rate stipulated in the loan contract.

• Forward contract – is a commitment to either purchase or sell a commodity at some future time and price.

• Futures contract – is a contract to either purchase or sell a commodity at some future time and price. These types of financial instruments are traded in the futures exchange market unlike forward contracts which is a private contract between two parties.

• Option – is a contract that gives the holder of the financial instrument, the right to sell or purchase an asset in the future. An option is a mere right, not an obligation to sell or purchase.

• Foreign currency forward contract – foreign currency denominated loans resulting from the importation of goods or availment of loans exposes the entity to foreign exchange (forex) fluctuations. Hence, as a protection against foreign currency risk, the entity enters into a contract with financial institutions to reduce forex risk.