The choice of the strategy for risk management is one of the essential steps that a bank must make in order to excel in the target environment. Hedging, in its turn, has been viewed as a tool for managing the financial risks that may emerge in the process of managing forwards and futures. However, the very concept of hedging itself is rather tricky; by adopting the specified strategy, one is likely to face a range of challenges primarily related to the opportunities for the economic growth of an organization and its further reputation in the eyes of its potential partners.
Indeed, according to the existing definition, derivatives can be viewed as the tools that reduce the risks that are intrinsic to futures and forwards1. According to the existing definition, the specified phenomena can be defined as the contracts that allow for a detailed distribution of responsibilities, including the financial ones, among the key parties. Particularly, futures contracts can be defined as exchange-traded, whereas forwards do not comply with the same rigid principles. Hedging, also known as derivates, in its turn, allows for balancing the risks related to signing the aforementioned contracts.2
Although hedging by definition is supposed to reduce the financial risks associated with signing a contract related to the distribution of the basic financial responsibilities, it, in fact, creates premises for a substantive threat to the overall well-being of a company by making it far too dependent on the firms that its leader signed a contract with.3 The risks that hedging may also trigger in signing the contracts involving forwards, futures, and options, therefore, is also aligned with the distribution of roles and responsibilities among the two organizations choosing to create a partnership.
In other words, it is the fact that a company shares a substantial amount of its information and liabilities with another organization, including details regarding its current debts, the financial status, and the basic assets that makes the situation rather threatening. Even in the instances when the key clauses of the contract are spelled out fully, and the needs of all the parties involved are taken into account, the instances of financial fraud are still a possibility. Therefore, by discovering the existing hedging options, a firm exposes itself to a variety of risks related to being deceived by its partner.4
Nevertheless, the specified risks can be addressed rather efficiently by creating a strong contract with clear implications for both parties as well as the identification of the legal principles that the operations of the companies are regulated by in the state in question. As soon as the legal boundaries of the firms’ choices are identified, the threat of being let down by a partner organization and, therefore, having to pay the liabilities that the latter was supposed to provide by the contract.5
The exposure to threats, which hedging presupposes, may also result in facing the risks of losing some of the organization’s customers due to the possible drop in the firm’s financial assets as a result of a poorly written contract signed as a specimen of forwards, futures, or options. The need to address the emerging issues such as meeting the financial liabilities that the partner may have defaulted on are likely to drain a company financially, therefore, reducing its competitiveness in the realm of the global economy. Consequently, the firm may lose its attractiveness as an investment option and the organization worth buying services from. The specified threat is especially huge for banks as the competitiveness rates are extremely high in the designated area, and clients are very likely to switch to a rival company as soon as the slightest issues emerge.6
The risk of having the net economic exposure of a firm is a result of a wrong hedging approach can also be viewed as one of the numerous threats that the specified strategy may trigger. In particular, the specified threat presupposes a significant drop in the economic growth rates and the following demise of the organization. Moreover, in certain instances, a company may even face bankruptcy unless the issues are identified at a comparatively early stage of their development and addressed properly.7
Therefore, when adopting the strategy of hedging to manage the signing of futures, forwards, and options, banks face the threat of losing their financial sustainability. Although hedging is typically viewed as the strategy that allows for a sharp reduction in the number of risks which a company may face when signing a contract with a potential partner, the concept of hedging itself presupposes facing several risks.8
Particularly, the risks related to defining the credibility of the organization, which the company in question is going to sign an agreement with, deserves to be mentioned as the primary risk to be taken into account. Although hedging allows minimizing risks occurring in the process of futures and forwards management, it still creates the environment for more threats such as the possibility of choosing an untrustworthy organization, which can be managed by the reconsideration of the risk management strategy and the choice of a different leadership approach.
Bibliography
Burton, Maureen, and Bruce Brown. The Financial System and the Economy: Principles of Money and Banking. New York, NY: Routledge, 2014.
Chance, Don, and Roberts Brooks, Introduction to Derivatives and Risk Management. Boston, MA: Cengage Learning, 2012.
Constantinides, George M. Financial Derivatives: Futures, Forwards, Swaps, Options, Corporate Securities, and Credit Default Swaps. London, UK: World Scientific, 2014.
Cowell, Frances. Risk-Based Investment Management in Practice. London, UK: Palgrave Macmillan, 2013.
Khan, Omera, and George A. Zsidisin. Handbook for Supply Chain Risk Management: Case Studies, Effective Practices, and Emerging Trends. Fort Lauderdale, FL: J. Ross Publishing, 2014.
Moyer, R. Charles, James McGuigan, Ramesh Rao, Contemporary Financial Management. Boston, MA: Cengage Learning, 2014.
Rossi, Clifford. A Risk Professional’s Survival Guide: Applied Best Practices in Risk Management. New York, NY: John Wiley & Sons, 2014.
Smith, Rob. Global Supply Chain Performance and Risk Optimization: The Value of Real Options Flexibility Demonstrated in the Global Automotive Industry. Berlin: Springer Science & Business Media, 2013.
Footnotes
- Frances Cowell, Risk-Based Investment Management in Practice (London, UK: Palgrave Macmillan, 2013), p. 144.
- Rob Smith, Global Supply Chain Performance and Risk Optimization: The Value of Real Options Flexibility Demonstrated in the Global Automotive Industry (Berlin: Springer Science & Business Media, 2013), p. 39.
- Maureen Burton and Bruce Brown, The Financial System and the Economy: Principles of Money and Banking (New York, NY: Routledge, 2014), p. 231.
- Clifford Rossi, A Risk Professional’s Survival Guide: Applied Best Practices in Risk Management (New York, NY: John Wiley & Sons, 2014), p. 402.
- Don Chance and Roberts Brooks, Introduction to Derivatives and Risk Management (Boston, MA: Cengage Learning, 2012), p. 382.
- George M. Constantinides, Financial Derivatives: Futures, Forwards, Swaps, Options, Corporate Securities, and Credit Default Swaps (London, UK: World Scientific, 2014), p. 61
- Omera Khan and George A. Zsidisin, Handbook for Supply Chain Risk Management: Case Studies, Effective Practices, and Emerging Trends (Fort Lauderdale, FL: J. Ross Publishing, 2014), p. 132.
- R. Charles Moyer, James McGuigan, Ramesh Rao, Contemporary Financial Management, (Boston, MA: Cengage Learning, 2014), p. 787.