In general, derivatives refer to a financial instrument that allows securing a certain value that is reliant upon a monetary asset. The most frequently utilized assets are stocks, interest rates, market indices, and bonds (Fernando, 2021). The derivatives might take various forms, including future contracts, swaps, options, and forwards which have different purposes and advantages (Fernando, 2021). These financial instruments are primarily used to achieve the financial goals of organizations and individuals and are frequently utilized in risk management; nevertheless, they require a significant academic background to operate and have a considerable number of downsides properly. Therefore, it is essential to critically evaluate the usage of financial derivatives in the business setting and assess the potential challenges based on real-life scenarios.
Derivatives in the Business Setting
As mentioned briefly before, derivatives are primarily used to achieve financial goals in the form of futures contracts, options, and swaps. Additionally, derivatives might be traded on an exchange or via the over-the-counter method (Fernando, 2021). The former refers to standardized exchange in regard to guarantees through a clearinghouse (e.g., Options Clearing Corporation (OCC)) and is defined by a high degree of liquidity (Fernando, 2021). It allows for a considerable degree of risk mitigation and stability. The over-the-counter (OTC) method generally refers to a less standardized method of trade via a dealer network (Fernando, 2021). Nevertheless, this type has a number of benefits: for instance, smaller companies that are not listed on official exchanges might utilize the OTC method to achieve their financial goals. Therefore, the two primary categories of derivate contracts provide diverse types of benefits and are frequently utilized for different purposes.
For each of the aforementioned processes of exchange, there are several types of derivatives. Futures are a particular type of contract between two parties or organizations that concerns the purchase of an asset at an agreed price in the future (Fernando, 2021). This type of derivative falls into the category of standardized exchange trade and is frequently used to mitigate financial risks via the technique of hedging or for speculation of the price of the chosen asset (Fernando, 2021). The second type of derivative contract is forwards, and their primary difference from futures is that they are traded via the OTC method (Fernando, 2021). It implies that the terms of the contract are frequently customized, and the degree of financial risk is higher. Another prominent type of derivative is options, and the primary difference from their aforementioned counterparts is the voluntary nature of the contract (Fernando, 2021). The parties of the agreement might buy or sell at a determined date in the future for a specific price, but they are not formally obligated to the contract.
Derivatives in Risk Management
Having recognized the primary functions of derivatives in the business setting, it is possible to evaluate their significance in risk management. The risk assessment and prevention models play an essential part in the business setting and directly affect the revenue growth and development of corporations. The common risks include fluctuations in interest rate, foreign exchange, and market risks. Frequently, it is impossible to account for all the potential contingencies; nevertheless, it is plausible to utilize financial instruments, such as derivatives to mitigate controllable risks. Therefore, despite the complexity of the subject, it is essential to continually research and develop the financial frameworks that allow for a safer and more profitable business.
There are different types of derivatives that are utilized for diverse purposes but are commonly utilized in the strategies of hedging and speculation. Hedging is a highly prominent technique that mitigates the risks of financial assets in the business setting (Downey, 2021). In some sense, hedging is similar to insurance since while it does protect the firm from potential contingencies, it might also decrease the possible gains and profits due to its cost (Downey, 2021). Therefore, investors frequently utilize this strategy to protect financial gains and minimize losses (Nickolas, 2021). Ultimately, hedging is the primary method to mitigate risks and potential price fluctuations via derivative contracts, such as futures or options.
Potential Challenges of Derivatives
Financial derivatives and hedging might be highly beneficial to the firms concerning risk management. The increasing popularity of derivative contracts is transparently demonstrated by the total amount of OTC trade via derivatives reaching US$493 trillion by the year 2016 and an overall 424% increase since the start of the century (Huan & Parbonetti, 2019). Nevertheless, these practices have their own contingencies and downfalls. The current academic stand on derivatives is uncertain since there is a large number of variables that affect the ultimate results of the contract (Bachiller, Boubaker & Mefteh-Wali, 2020). Some experts believe that hedging might reduce financial distress costs, increase the leverage of the company, and mitigate risks; at the same time, the diverse perspective demonstrates that hedging might be detrimental to revenue growth and is ineffective in reducing contingencies (Bachiller et al. 2020). As a result, various experts cannot seem to find consensus on the effectiveness of derivate contracts and their relation to firm value.
Primarily, the uncertainty concerning derivatives arises from the mixed findings by the academic departments. Bachiller et al. (2020) have researched 51 empirical studies concerning financial derivatives and identified no clear-cut conclusions. The primary variables that affect the derivative contracts are the type of exchange, model specifications, currency, location, methodologies, the financial state (the potential consequences of financial crises), and the type of commodities (Bachiller et al. 2020). Furthermore, the research data is primarily based on the financial reports of derivatives which might slightly deviate from the objective evidence (Bachiller et al., 2020). Therefore, there is a large number of variables that hinder the research process and affect the ultimate outcomes. Another study demonstrates the specificities of derivatives in banking business models: a reasonable quantity of derivative contracts tends to reduce risk, while more extensive strategies increase the number of potential contingencies (Huan & Parbonetti, 2019). Therefore, the research demonstrates that real-life scenarios do not necessarily reflect the theoretical advantages of derivative contracts and might even be detrimental to firm value if exploited irresponsibly.
References
Bachiller, P., Boubaker, S., & Mefteh-Wali, S. (2020). Financial derivatives and firm value: What have we learned? Finance Research Letters, 101573, Web.
Downey, L. (2021). Hedge. Web.
Fernando, J. (2021). Derivative. Web.
Huan, X., & Parbonetti, A. (2019). Financial derivatives and bank risk: Evidence from eighteen developed markets. Accounting and Business Research, 1-28, Web.
Nickolas, S. (2021). How can derivatives be used for risk management? Web.