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Use of Derivatives in Risk Management

Derivatives and Risk Management in Corporate Finance

In the corporate finance, there are two thematic structures to be presented in order to foster the understanding and application of management principles in the physical context. There is the use of the term derivative and the other one being risk management which together are dependent on one another and meant to create meaning in the modern field of finance and to enhance financial knowledge among adults. Basically, the two parts are supported on strategy and the asset structure.

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In the corporate world, having money or assets is not the end of matter; the management of this matter is of paramount importance in defining its sustainability or even an organization as a whole. According to Ross et al. (2009), derivative first used in financial aspect by Mark Rubinstein in 1976 was confined to options alone but later on given a new meaning as a financial agreement or contract whose value is dependent on the price of the underlying asset. Again, in this context the term option is also presented but diversely expressed on the basis of a price depending on whatever is already there, the structure of an asset and its future survival, the strategy for monitoring it.

Due to this, the term derivative has become part and parcel of the business world to help in proper management contrary to what was initially misconstrued as a financial instrument of the devil (Pablo, 2006). A 2003 report by the International Swaps and Derivatives Association (ISDA) indicated that for a long time, derivatives were not a preference of the corporate world but which now over 90% of the major financial companies cannot do without (Pablo, 2006). The reason is that its inception engineered good financial practices which in return contributed to the blossoming of corporations by giving them an assurance over a wide range of risks encountered in day-to-day business.

In this regard Pablo (2006) notes that most new commodities in the world market have now been designed with corporate needs in mind and which behooves every adult to understand. This is a form of risk management since it acts as a contract between two parties as a guarantee. This is a crucial instrument that every adult must understand. According to Troy (2006), the greatest danger faced by adults in the modern world is lack of knowledge about corporate finance. In the streets are many people with different perceptions of the financial practices for which even the aspect of guarantee offered amidst good practices is bleaker but not lacking. Perhaps, the key problem has been the misunderstanding of the term risk management before coming to grips with the derivatives as its endpoint.

Risk Management

Risk management, a term traditionally used only when attempting to identify and manage the inevitable which could hamper a business process or even lead to the downfall of an organization is all knew to most adults. It has largely been used when focusing on matters related to insurance as a tool for compensation in the event a threat strikes big financial companies but not individual assets. Risk management is about assets irrespective of corporate views or individual interests. So, here again, the asset management is also seen as two fold in approach in the sense that it lingers round both the options and the future of the underlying asset; there is the aspect of both strategy and structure as compensatory policies. According to Barry (1997), the task of risk management therefore depends on the understanding of the ‘why’ and the ‘how’ of it before undertaking the process. The ‘why’ in this case is what basically defines risk management in a wider sense as the overall corporate strategy; one that provides a crucial balance between assets and strategy on one side and capital structures on the other.

On the other hand, the ‘how’ in risk management relates with the key understanding of derivatives as an agreement between two parties whose value is determined by the price of something also referred to as the underlying. It is the epitome of risk management that addresses two parties with respect to the future of the underlying and thus the key compensatory element which every adult needs to understand in the changing times of technological innovations marked with the fluctuations in the exchange rates (Pablo, 2006). The corporate financial engineering faces the twin challenges with regard to the best option consideration amidst income volatility and the changing times and which in this case refers to valuation. The ‘why’ and ‘how’ are no a stand-alone principles since each implies the other on the basis one begins the process and the other ends it to give hope to those party to the contract. From the definition of corporate finance as an area of finance that handles financial policies made by an organization or corporations by use of tools and analyses, there is one fundamental point to take into consideration. Corporate finance exists as an entity in a society where business is taking place with the various classes of people around.

Therefore, in talking about tools and analyses, attention should focus largely on sound management practices for both the intermediaries (dealers) and the end-users of these derivative instruments. That too depends on the choice of derivatives to use in expediting a contract. This varies from factors contingent with the underlying in terms of relation with the derivative, its type, market type where the contract is carried out and the mode of payment that guarantees some premium or else bound to criticism because of notable losses in situations of lack of preparedness (Troy, 2006).

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Choice of Derivatives for Use

A very necessary tool for risk management is the choice of the derivative to be used. Every adult is not endowed with the same asset and therefore the choice of derivative, which at some point may not be influenced by the exchange rates or currencies, is a buttress of hope in the risk management strategy. As a financial contract between two parties contingent with the underlying, derivatives come in different forms but for the same reason, security. However, the choice depends on certain factors which must be taken into consideration in order to facilitate risk identification and quantification

First and foremost, there must be a relationship between the derivative and the underlying which may be short term assets or even long term assets. One must be able to identify the most appropriate derivative as a principle in risk management (Ross et al., 2009). Among these derivatives are found swaps, options, and futures among others. What determine the swap are the different rates of exchange where the owner is authorized by options with no obligation to transact an asset through buying or selling. The other determinant of the swap is the standardized contract referred to as future which allows an asset to be transacted even before maturity of the time specified but at the current price.

The type of underlying is a key to proper identification and quantification of risk issues. It can be long term or short term where for instance derivatives on interest rate which can be used as a credit swap transfer between the buyer and the seller. On the other hand, market type where the trading takes place is also important. For example, the largely unregulated OTC (over the counter) derivatives which are traded directly independent of a dealer may be long on promises but short in performance which may end up inviting criticisms. The exchange-traded derivative where derivative instruments are distinctively applicable for transparency and security may be appropriate.

Mode of payment is important, where in the active world of derivative markets, the derivatives have remained neutral on their own until when put to use. Finally, knowledge of the underlying is very important. This is also the most overlooked area in the choice of derivatives and where most contracts have only benefited one side. The process of valuation of non-linear commodities has seen many people enter into a contract by trials largely because of poor education. Education here is not limited to class work but field exposure. As a matter of fact, the problem has been found not to be with the derivatives but the people’s use of the derivative instruments.

Educating Adults

Education of the people is a very important aspect in meeting the needs of the changing world. It is notably right to say that people have great assets everywhere and the corporate finance is better placed to manage all these. The implementation of risk management policies requires an ongoing reflective process in which there are key reminders of the new policies and their application in the changing world of technological innovations (Troy, 2006). Most adults or generally most people in the corporate world earlier referred to intermediaries cannot identify risks or even quantify them. Asset growth and continuing technological developments need to revolutionized risk management strategies but which is contrary to the expectation due to lack of knowledge on the use of derivative instruments.

Derivative as a by-product of the corporate finance has seen an increment in asset volatility and led to a corresponding increase in demand for risk management strategies. This demand is reflected in the growth of financial derivatives from the standardized exchange-traded derivatives to the larger over-the-counter (OTC) systems of the old (Barry, 1997). In the process of all these, there is need for better methods which can easily be understood by most people opting for the easier way out.

Strategy: Value at Risk (VaR)

The guiding principle here should be based on recorded statistics by management. Most risk management firms tend to use derivatives but with great failure due to proper strategy. There have been several great losses experienced by dealers and end-users. According to Pablo (2006), a factor that has contributed to these losses was lack of coordination in corporations. Moreover, there has been an excessive risk-taking backed by insufficient understanding of the choice of the derivative for the asset. These two notable failures serve as a reminder of the importance of strategy associated with risk management as earlier stated that risk management strategy is about corporate strategy which must be established to identify, measure, monitor, and control exposure. Therefore, derivatives as devices for risk management must first and foremost be managed from a corporate perspective. According to Troy (2006), it is important to have a corporate culture where all values such as believes and rituals are considered in order to come up with a viable mission statement.

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Financial derivatives as instruments that primarily derive their stock of meaning from the performance of the underlying must be used with great precision. There have been several widely publicized reports on large derivative losses experienced by banks and corporations because of identifying and assessing risks as a bloc and not each risk separately (Barry, 1997). Contributing to these losses therefore were inadequate board and senior management oversight, excessive risk-taking, insufficient understanding of the products, and poor internal controls and hence a battle of minds and hearts.

Therefore, a most viable and practical strategy should be one that does not entail mutual exclusiveness of the events; the choice of derivatives and the use of the choice should not cancel out each other but instead should imply the other. As a concept of corporation then, the Value at Risk (VaR), a name of a risk management by which senior management can be informed through a single number is necessary (Ross et al., 2009). Earlier, we noted in risk management that the ‘how’ is as important as the why. But now, with the growing number of dealers everywhere, the only acceptable standard for measuring exposure to financial price risks is only through the use of VaR. This is a system which is now everywhere but still not with every person. For this reason there is absolutely a great need to deal with both the dealers and the end-users not only from the standpoint of financial transactions but through exposure to sound management practices.

Therefore, as we look keenly on the corporate culture, there is also a need to have a financial culture in which the intermediaries and the end-users undergo financial drilling to help guide in matters of risk management (Ross et al., 2009). Valuation is a key to success if derived from mutual understanding since risks associated with derivatives are neither new nor exotic. Mutual understanding here implies that not all transactions can be carried out by the intermediaries but that at certain instances the end-users which in this case are adults can decide to transact a derivative as a substitute for cash. In this regard, there are two types of end-users or adults who need this education: there are those who are referred to as active position-takers and will have preference for derivatives relative to their total asset size. There are also those who are referred to as limited end-users and whose main aim is to use derivatives as an investment option or as a way of managing risks using structured notes. These two need to be empowered to make informed decisions in line with their choice.

One point we cannot deny at this point is that both the active-position takers and the limited end users have in various circumstances incurred great unrecorded losses for which some have described them as rogue traders (Troy, 2006). But this should not be blamed on them but rather the use of derivative devices either presented to them or made to sound like a notion by the corporate world. Thus they are rogue traders because there were rigged policies which did not match the derivatives or the risk to be managed. Using VaR as a strategy then will help highlight loss recovery and enhance exposure stabilization. The strategy in risk management that is implemented as well as developed in order to stabilize the cost of the yield is know as stabilizing the exposure.. It helps as a recovery tool and which in this case is a compensatory element, a characteristic we discovered is with the derivatives. Therefore, in thinking about structure which is to be managed, strategy is the endpoint of all happenings. Most adults have structures, some are over-structured but managing them using defined strategies will not only enhance the corporate finance from achieving its goals of 100% derivative compliance but will also empower people to make informed choices when undertaking any derivative as an instrument in risk management.

References

Barry L. (1997). Risk management of financial derivatives. Darby, PA: Diane Publishing books.

Pablo T. (2006). Corporate derivatives: Practical insights for real-life understanding. London: Risk Books.

Ross, S., Westerfield, R.W., Jaffe, J.F., & Jordan, B. D. (2009). Corporate finance: Core principles & applications. New York: McGraw-Hill/Irwin.

Troy A. (2006). Corporate finance demystified. New York: McGraw-Hill.

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