Discuss the roles of financial derivatives in general and explore how futures and options can help risk managers to hedge financial risk in particular?

Introduction

Derivatives are defined as substances that are created from others as defined in chemistry . Similarly , financial derivatives are instruments that allow value exchanges based on pre-existing acts . Usually , the owner of the real stock enters into an agreement with someone who will be willing to buy that stock at an established price at some time in the future . The latter is the most common form of arrangement . However other agreements in the market do exist . The purpose of a financial derivative is to give a stock owner or purchaser leverage (control

of a large stock using minimal investment . Leverage is not only applicable in the field of financial derivatives as it is common to use in other financial sectors such as insurance , real estate etc . However , there is a flipside to this argument , sometimes , the stated amount chosen for the financial derivative may be inaccurate i .e . the future may work against the stock owner . In such scenarios , it would have been advisable to deal with direct payments rather than through the use of derivatives (Thomas et al , 2000

In fact , there have been numerous disasters in a number of financial institutions because of the use of financial derivatives . For example in England , the Barings Bank failed miserably as a result of the risk that the bank incurred after making a financial derivative . One of the company 's representatives made trades that did not come into force in the future i .e . in 1995 , this caused substantial losses to the bank such that it was declared bankrupt in the end . Additionally , many investors such as Buffet Warren (one of the world 's leading financial investors have expressed their disapproval of financial derivatives claiming that they are bound to fail (Pilipovic , 1998

The essay shall look at both sides of the coin i .e . the benefits and risk of financial derivatives . Specific attention will be given to futures and options as forms of financial derivatives and recommendations given about how risk managers can use the latter to hedge financial risk

The role of financial derivatives

Financial derivatives have two major roles . These are

Speculation

Hedging

Financial derivatives are instrumental in the hedging process because through them , parties can exchange risk . Usually , this is possible through the use of an underlying asset or a stock that actually exists The underlying asset gives one party the opportunity to shield themselves against a potential risk in the future while the other party also does the same . Taking the example of an electricity generator and an electricity distributor the manufacturer may not be sure about the future price of his service and is therefore at risk in the future . On the other hand , the electricity distributor may not be sure about the availability of electricity . If these two parties leave their uncertainties to chance , then they could be vulnerable in the future However through financial derivatives , it is possible for the electricity manufacturer to be sure about the process which he will receive for...