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Critical evaluation of Use of Derivative instruments within firms within financial risk mitigation.

Writer's picture: Evelina TiltaEvelina Tilta

Almost all decision making consists of financial and economic risks. The choice between investment options is the actual problem not only for large incorporations but also for individuals. For instance, the Bubble crisis in 2007-2008 signified, that financial risks taken by individual parties can also be correlated with costs for parties rather than the risk creator, who is both outside and inside of the financial system, which means that the creation and dispersion of financial risk obviously can harm both business world as well as society (Heinemann, 2011).That is why risk management shall focus not only on the predominant company’s risks but also shall evaluate future risks that affect the whole market situation (LSBF U5, 2019).


The most common risks to forecast are credit, market, and operational risk, meanwhile operational risk is considered as non-financial risk (LSBF U5, 2019). But since the financial market and business as a whole has drastically changed, especially in the context of financial derivatives, the new strategies of how to mitigate financial risks were involved.Derivative instruments are financial instruments that have values derived from other assets such as stocks, bonds, or foreign exchange, thus, a derivative is a financial instrument with a price that depends on, or is derived from another asset (Nickolas, 2019; Hall, 2019). Most commonly derivatives are connected to hedging, which main purpose or strategy is to protect a position from losses (Nickolas, 2019; Ramzan, 2018). In this case, the protective put works as a necessary add-on for financial instruments for investors, which the main clue is the protection of a stock that has increased in value (Nickolas, 2019).

The most common ways of derivative use for hedging include foreign exchange risk, hedging interest rate risk, and product input hedge, but, nowadays, the invention of other derivative uses is continuing to develop (Hall, 2019). Different theories and methods of derivative instruments within the financial sector are applied, beginning with Portfolio Theory and Capital Market Theory (CAPM), ending with Extreme Value Theory (Avdulaj, 2011), Value at Risk (VaR), and Expected Shortfall (CVaR) (Avdulaj, 2011; Ramzan, 2018).



Thus, according to Simone Heinemann, four main forms of derivatives exist like futures, forwards, options and swaps (Heinemann, 2011). Each of the instruments has their own functions, for instance, according to the situation in contemporary stock markets, the fast moving changes in foreign exchange and commodity markets have real influence on business confidence, as well as on local and global economies (Ngunjiri, 2018), and, thereafter, companies trade across the boarders and the impressive amounts of deals are realised in foreign currencies, thus, currency exchange is affected both by the spot market and economical factors such as sanctions, the forward contract derivative is helping to sell or buy currency at a set rate at some point in the future (LSBF U5 V6, 2019).



Despite the positive purpose derivative instruments have also a negative side, for instance, the forward contract which by fact is defined as a private agreement between two parties giving the buyer an obligation to purchase an asset, logically, the seller to sell an asset, at a set price at a future point in time (Investing Answers, 2019), the main disadvantages include lack of benefit from favourable movements in exchange rates (Kaplan, 2012). As an example for unsuccessful forward contract business relations is Netflix’s failure with hedging in the digital economy (PYMINTS, 2018).Except for unpredictable exchange market changes even with forward contracts like Netflix’s case in 2018, derivatives can mask the debt loads.

One of the most famous examples is the Greece Crisis in 2010 when derivatives helped Greece to mask their debt loads because of creditdefault swaps (Morgenson, 2010). This dirty use of financial derivatives as swap contracts brought up additional examples of unsuccessful deals. For instance, NY State paid $103 million to terminate roughly $2 billion worth of swaps - more than a quarter of which resulted from the Lehman bankruptcy in September 2008 (Morgenson, 2010). A similar situation was with options and futures derivatives. For example, recently Options Clearing Corp.(OCC) was slapped with $20million fine for risk failures, because according to the Securities and Exchange Commission and the Commodity Futures Trading Commission, OCC was charged because of failing to establish and enforce procedures to test risks (Stafford, 2019).However, the main purpose of derivatives in the use of risk management practices is to provide security on long-term deals and provide the best conditions that can be approached from both parties (Hentschel & Kothari, 2001).

But, there also do exist seven unstated uses of derivatives that can cause the opposite - create a crisis. Those seven uses of derivatives are: permitting the impermissible, disguising risk, beating Basel, avoiding Law Suits, inflating profits & hiding debt, evading Maastricht, circumventing Stock Market Rules (Hildyard, 2008). And, still, even in this case, examples of failures and “dirty” use of derivatives is not changing the bipolarity of the derivatives as a thing itself. Because by accepting conditions on specific exchange terms, never- mind if these are futures contracts, forward contracts or options, or swaps, both parties already assume that the loss is still possible, and some risk causalities simply can not be forecasted either by human resources, neither by computers. So here comes an important conclusion on risk management, firstly, it refers to the process of understanding, secondly, on mitigation, and thirdly, on sharing of risk (Ramzan, 2018). Therefore, risk management, both with derivatives as financial instruments or without, is not about what will happen in the future, it is about how to deal with problems in advance that might happen. Thus, the role of derivatives in risk management does exactly the same function as risk management with any other financial instruments.


In conclusion, the use of derivative instruments within companies to reduce risks is obviously positive and important until those instruments are used ethically properly, which means the functions of securing business from possible failures or bankruptcy are performed clearly, honest and transparent. But, if derivatives are used to cover debts, as in the case with Greece, and, thus are more related to money laundering, the idea of risk mitigation fails. Unfortunately, despite the active lawful and regulatory fight against dirty derivatives, it is not easy until nowadays to be 100% sure that derivatives are clean. This means, that hand to hand with derivatives that serve for saving the global market against financial crisis, do exist dirty derivatives or fraud derivatives that potentially cause the financial crisis (Bedi, 2013?).


First time published as a part of assignment in London School of Business and Finance, December 2019 by student E.Tilta (MscF/ Masters in Business Administration).


Recources

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