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The Use of Derivative Securities in Financial Risk Management Research Paper

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Updated: Sep 9th, 2021

In financial risk management (FRM) the use of derivative securities is considered one of the most significant evolutions of the business world. And the use of derivative securities for financial risk management is almost adopted for both financial and non-financial organizations. In this regard, business managers and stakeholders often use quantitative tools as a means for detailed information for financial risk management. Beforehand, with the use of detailed information gathered from quantitative tools calculations managers can assess the financial risks of their organizations. However, these tools have gained much popularity, especially in the private sector. Interestingly, banks and securities firms are some of the primary adopters of these financial risk management tools.

The Purpose of the Financial Risk Management

Firstly, the main reason behind the adoption of financial risk management in any firm is to timely find out the reasons for risk faces by a firm. Secondly, after determining the financial risks factors suggesting appropriate tools for managing detected risks.

In finance, a “derivative security is a contract that specifies the rights and obligations between the issuer of the security and the holder to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event”. (Ahmed, 2006)

Obviously, in today’s world of complex business, for both public and private firms determining, understanding, and managing financial risks have become a primary motive. In this regard, FRM practices in private organizations have broadly accepted practice tools designed to manage financial business risks, and that could lead to a firm’s business financial fiasco if not handled appropriately.

Ahmed (2006) believes that because of its populating in the financial business world, financial risk management practices have also been adopted by firms whose business is not mainly financial.

The Use of Derivative Securities in Financial Risk Management

Financially speaking, derivative instruments include swaps, futures, and options, with their presence in any public or private firm business managers or directors with a variety of methods can control a firm’s possible financial risks. The main reason behind the rapid acceptance of these financial risk management securities is that in the presence of these financial risk methods now it has become possible that firms can easily adjust their financial burdens. Luckily for private organizations, because of the presence of derivative securities separate entities such as primary speculators are always happy to bear the unwanted financial risk of private firms against contingent profit. In theory, the organization that likes to get rid of its financial risks is always happy to pay speculators to bear that financial risk for them. Nonetheless, “The system works provided that the speculator demands less to bear this risk than the costs to the firm of maintaining the risk in-house”. (Richard and Buttimer, 2001)

Reason for Usage

In the present business world, both non-established and established organizations use derivative securities as a solid tool to transfer organizations’ financial risk. For instance, before the crops grow a farmer can sell his harvest by making a future contingent contract with a speculator. In this business deal, the farmer shifts his financial risk burden on the shoulder of the speculator. In this case, the speculator will bear or profited in this deal, depends on harvest future prices or growth. To the farmer’s end, somehow he knows the amount he will get in the future from his produced harvest, but he wanted to avoid a burden of financial risk that is why he sold his harvest to the speculator. (Ahmed, 2006)

Geoffrey (2002) believes it is very difficult to say something about derivative securities. However, it is understood that derivative security such as options, futures, or swaps containing a claim. And most importantly, it has some special characteristics, such as the price that is derived from some future events ‘contingent events’ depends on some future circumstances. He also believes that “This event is often, though not always, associated with a security or commodity delivery to take place at a future date.” (Geoffrey, 2002)

The Financial Risk Management Process through Derivative Securities

An organization by simply buying offsetting derivative securities can pass the organization’s financial risks. However, the procedure is not easy, and it needs a great understanding of your exposures. Moreover, the financial risk management process requires a clear and sound knowledge of all derivative securities such as future, options and swaps, and their applicable accounting rules & regulations as required by IAS39 or FAS133/138. In addition, to get the maximum benefit from derivative securities, an organization must assure that it has sound internal control. In this regard, a completed and balanced risk management system comprises of three interacting elements and it is backed by equally within each area:

The three interacting parts are:

  • Control.
  • Economics.
  • Accounting.

Control. In this regard, an organization needs to answer the following questions:

  • Does the right individual have the right set of appropriate tools?
  • Our board and management getting accurate and in-time information to make decisions?

Normally, using derivatives in the financial risk management (FRM) control process includes the following vital areas.

Economics. In this context, hedging defines economically the value of financial risk management, and it typically commences with an in-depth appreciation of exposure and its effect. Furthermore, it adopts through to the effect of one’s hedging action in countervailing the risks before one handles it, one should be able to measure it. An organization as part of the economic analysis should do:

  • Identify/measure risk.
  • Quantify the impact of risk.
  • Determine corporate risk management philosophy/risk appetite.
  • Develop risk management strategy/objective.
  • Execute strategy.
  • Monitor / evaluate performance. (Strategic Treasurer, n.d.).

Accounting. In this regard, for the hedging activity, accounting is considered as the final chief area of focus within the procedure involves. However, in this area, hedging activities require a sound practice of either FAS133/138 for US-listed corporations or IAS39 for EU-listed companies. Nonetheless, the main requirements here refer to:

  • Hedge designation.
  • Documentation.
  • Valuation.
  • Effectiveness assessment.
  • Financial statement impact.
  • System requirements. (Strategic Treasurer, n.d.).

Some Facts & Figures

In the present business world, to handle different financial risks like foreign currency risk, interest risk, and so forth, both large and small-scale organizations use derivative securities as part of an overall business system. Historically speaking, misuse of these derivative securities resulted in organizations’ financial fiasco. In this regard, Ahmed (2006) a researcher in this area has studied several firms’ financial disasters because of misuse of derivative securities. For example, because of Copper Futures in the year 1996 Sumitomo Corporation lost three thousand five hundred million dollars. From oil Futures, in the year 1993 Metallgeselschaft lost one thousand eight hundred million dollars. From FX Derivatives in the year 1994 Kashima Oil lost one thousand five hundred million dollars. Orange County in the year 1994 from the Interest Rate Derivatives lost one thousand seven hundred dollars. Barings Bank in the year 1995 from the stock index and bond features and Options lost one thousand four hundred dollars. Abovementioned all the organizations have made huge losses through the buying and selling of derivative securities. Ahmed (2006) believes that all the abovementioned organizations have suffered huge losses because of the misuse of derivative securities.

Some of these disasters have involved unauthorised trading (e.g. the Barings bank), raising the possibility that a significant number of companies may not have in place with appropriate controls or monitoring procedures to regulate their derivative positions”. Thus, it is very important for all organizations who manage their financial risks through derivative securities to keep in practice balanced and well-defined risk management policies. Organizations can declare illegal derivative use for speculative purposes. (Ahmed, 2006)

Concerns about Derivatives Usage

In today’s business world the use of derivative securities involves many views. Hence, regarding the use of derivatives for financial risk management organizations often check their degree of business concern about series of derivative views. These views typically include: cost of the transaction, insufficient knowledge about the use of derivative securities, difficulties in quantifying the organization’s exposure, derivative pricing and valuing, investors’ perception towards derivative, risk of financial credit, legal and tax issues, need of disclosure, judging the risk associated with derivative transactions and so forth.

Certainly, derivative securities can be traded by more than one speculator, moreover, they can be sold to hedgers there are no restrictions on their trading. In this regard, it has been observed in most of the financial derivative markets that the value of speculative trading is more than the actual hedge trading. Often, in financial derivative marketplaces, derivative dealers also look for arbitrage chances among various derivatives on identical or intimately related implicit in securities for instant speculation. Besides financial risk management, derivative securities are considered as a solid tool to achieve an economic exposure to implicit in security normally in cases where direct possession of the implicit insecurity is too pricy or prevented by government or other legal bodies. “In the year 1995, speculative trading of derivatives marked as most ill fame when illegal investments in index futures were made by Nick Leeson a Barings Bank dealer”. (Money Science, n.d.)

In addition, because of his limited knowledge about the market, irresponsible or advanced trained management, and unfavorable investment environment Nick lost approximately 1.3 billion dollars which are in history considered as one of a big loss through the use of derivative securities.

Warren Buffett a big player in an interview given to the New York Times said that “he had accumulated his wealth without the use of derivatives and that he regarded them as ‘financial weapons of mass destruction’, an allusion to the phrase ‘weapons of mass destruction’ relating to physical weapons which had wide currency at the time.” (Money Science, n.d.)

Nobody can deny the statement that derivative securities offer the general public and business players an opportunity to invest and earn a good amount. However, as discussed above because of its fragile nature investors are sometimes shocked by huge losses. In this regard, big players of derivative marketplaces always caution against this, by making authentic calculations and realizing the fact that in the derivative securities marketplace one can face huge sudden and unexpected financial loss. Especially, before going to invest, small investors always think about thousand times in this type of market. One can say that a better view to investing in the financial derivative market is to keep in mind that the main reason for derivatives is as a form of insurance. It means, to pass risk from others who cannot yield a huge loss to a person who could bear the loss or in a position to hedge against the risk by purchasing some other derivatives.

Economically speaking, derivatives play a tremendous role in financial risk management for those organizations who know how to handle it according to the conditions. Another important factor that also needs to be taken into consideration is that derivates may become a huge cause of an organization’s financial crises. However, because of the derivatives market nature that someone gains money and someone losses money in buying or selling derivative securities, it can be said that economic activity is going well which is good for both an organization and for a country. However, one cannot predict anything in this market that how much one would gain or lose. So, to put to the best use of financial derivatives in financial risk management an organization must have sound management policies when facing an unexpected decline in derivative value.

Conclusion

Conclusively, financial risk management through derivative securities is not an easy task, and this thing requires a sound knowledge of a firm’s overall financial position. Because it contains a complex process, FRM through financial derivative also requires the right personnel with a sound understanding of derivative, strategy & control, and most importantly hedge accounting. Besides, FRM needs at the forefront a sound knowledge of the risks one’s organization is exposed to, and as significant, management’s risk preference. And it can be said that a balanced and completed risk management process may not stand on its own if its structure does not have a strong strength of each leg.

References

Ahmed A.M. (2006). Derivatives use and risk management practices by UK non-financial companies, Journal of Managerial Finance, 32, 137-159.

Geoffrey P. (2002), Risk Management, Speculation, and Derivative Securities. Elsevier Speculation.

, (n.d.), Derivative Security.

Richard J. Buttimer, Jr (August 2001), An introduction to Financial Risk Management in Government. Web.

Strategic Treasurer, (n.d.), Financial Risk Management Premier. Web.

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