Derivatives and Risk Management

FINANCIAL RISK MANAGEMENT
NAME: MEHBOOB ALAM

REG NO 11570
TOPIC: How We Use Derivatives
Before we can begin looking at different types of derivatives-based risk

management in detail, we first must understand what derivatives are. Simply put, a
derivative is a form of financial tool that is reliant upon (or derived from) an asset.
Derivatives and risk management
Derivatives are most frequently traded in order to hedge (reduce risk) or speculate
(increase risk with the aim of making a financial gain), and their value is set
according to the supply and demand for the underlying asset.
Derivatives Management
We primarily use derivatives linked to commodities and currencies, however

markets are also available with the underlying asset as interest rates, market
indexes and bonds.
How Can Derivatives Be Used?
Derivatives can be used in a variety of ways: to hedge a position, to speculate on

the future price movement of an asset, or to give leverage.
Historically, derivatives were created to facilitate global trade across different
currencies. As goods were more frequently traded across borders, the need for a
balanced exchange rate system became vital, as traders across the world needed a
process to help them manage price differences dependent on currency. If, for
example, a British investor whose accounts were in sterling wanted to purchase
shares of a US company using dollars, they would be exposed to exchange rate risk
– the value of the pound may drop or rise against the dollar across the period of
investment, affecting the value of their investment. To eliminate this risk, the
investor could buy a currency derivative in order to secure a fixed exchange rate
and secure their funds.
Types of Derivatives
There are two ways which derivatives are executed: over-the-counter (OTC) or
exchange traded. OTC derivatives make up the larger proportion of the derivatives
market and are traded outside of an organized exchange or market – instead, they
are traded directly between two parties. OTC trades can provide significant
flexibility as the price and terms quoted for the asset can be altered based on the
risk appetite, book position (the amount and type of trades held by that
organization) and market view of those involved. However, because of this, it can
have a higher level of risk associated with it. In particular, this relates to
counterparty risk, which is where there is a danger that one side of the agreement
might default, meaning they do not fulfill the obligations set out in the agreement.
An example of this would be not settling an account on an agreed date.
On the other hand, exchange traded derivatives are transacted on an organized
exchange, for example the New York No.11 futures market, which is one of the
major sugar markets. Here each counter party transacts anonymously through the
exchange and, through a system of initial and variation daily margin calls
(effectively forms of deposit) which is managed by an institutional middleman
known as a clearing house, the counterparty risk is significantly lower. The nature
of an organized exchange means that there is full transparency over the amounts
and prices of bids made and transacted (there is plenty of terminology about the
different types of bid – look out for our glossary for more information).
Future Derivatives
Futures contracts are an agreement between two parties for the purchase and
delivery of an asset, whether it be sugar, starch-based sweeteners, PET or dairy, at
a pre-agreed price and date in the future. Futures contracts are standardized
because they are traded on an organized exchange (more on the exchange here),
which sets the terms of those contracts.
Hedging Derivatives
Traders can use futures to ‘hedge’ their risk or to speculate on the price of an
underlying asset. Hedging is the process of insuring against a negative event or
risk. Through securing a price that is deemed affordable for a purchase or sale in
advance of delivery, the subsequent impact of price changes is avoided. As an
example, white sugar futures (against which most global refined sugar trades are
based) have traded between $875/MT and $300/MT since 2011 – the fluctuations
between these levels will clearly have a significant impact upon both producers
and buyers of this product. Importantly, the ability to secure future values gives
producers and consumers the ability to independently hedge the market when
levels are affordable (i.e. at different times for the buyer and seller), avoiding
volatile spikes and troughs in price.
Future Derivatives: Example
This is all pretty abstract, so let’s go through an example to show what we mean.
Company 1 needs sugar in October next year, and is concerned that the price will
soon rise. To protect against this, they purchase an October sugar futures contract
at $400 per MT (this transaction is known as the contract execution). This means
that the seller on other side of the contract (let’s call them Company 2) is obliged
to sell Company 1 that sugar at the set price of $400 per MT once the contract
expires. The delivery method, quality and other terms will be defined by the
exchange rules.
If, between the execution of the futures and the contract expiry, the price of sugar
rises, Company 1 can decide whether to sell the contract at a profit, or to receive
delivery of the sugar at a price below where the prevailing market is at. If the
former, Company 1 can sell this contract to Company 3 at the prevailing higher
price than when they first bought at and retain the profit. At expiry, Company 2
now delivers the sugar to Company 3, with each paying the levels at which they
executed the futures.
With this example, both Company 1 and Company 2 were most likely hedging risk
but for different reasons. Company 1 needed sugar in the future and wanted to
insure against the risk of the price rising in October next year by purchasing a
futures contract. Company 2 needed to sell their sugar and were happy with the
current levels offered on the market. Both parties therefore mitigated their risk by
executing a futures contract and securing the market price.
In that example, the contract was settled with the physical delivery of the
underlying asset (the sugar). However, this is not always the case. Many traders
hold positions and cash settle (closing the contract without taking delivery of the
physical good) before expiry, meaning any profit or loss on the trade is settled as a
positive or negative cash flow to the traders’ accounts. As long as these positions
are closed off (buying or selling to bring the number of contracts you hold back to
zero) before expiry, the traders involved are fulfilling their contractual obligations
and won’t have unexpected tonnages arriving in inconvenient places (and therefore
this approach particularly suits speculative traders who have no interest in
receiving or selling the underlying asset). Many futures contracts do not suit
physical delivery (lean hogs are a good example of this) and so are cash settled as
standard rather than physically delivered. Here, even futures that are left open until
expiry are settled based on the difference between the price at which the hedge was
executed and the price when the market expires.

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FINANCIAL RISK MANAGEMENT

NAME: MEHBOOB ALAM

TOPIC: How We Use Derivatives

Before we can begin looking at different types of derivatives-based risk

Derivatives and risk management

We primarily use derivatives linked to commodities and currencies, however

How Can Derivatives Be Used?

Derivatives can be used in a variety of ways: to hedge a position, to speculate on

Future Derivatives: Example

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