Derivatives as a tool of Financial Risk Management

Managing Financial Risk is one of the most essential activities that every firm needs to consider. Financial risk is the type of risk that involves financial loss to a firm. Financial risks can be classified into various types such as Market risk, Credit risk, Liquidity risk and Operational risk. Further, market risk is classified into directional and non-directional risk, credit risk into sovereign risk and settlement risk, liquidity risk into asset liquidity risk and funding liquidity risk and operation risk into fraud risk, model risk and legal risk. After realizing what financial risk is and its types, the next major concern for firms is to perform financial risk management. Various tools were and are used for managing financial risk and out of all derivatives are the most widely used tool to manage financial risk. Let's discuss derivatives as a tool of financial risk management in this post.

What are Derivatives?

Derivatives as the term suggests are private contracts that derive value from underlying assets such as bonds, currency, indexes and so on. There are different types of derivatives used as tools of financial risk management. Below are the most popularly used ones:

Types of Derivatives:

• Forwards Derivative Contract
• Futures Derivative Contract
• Options Derivative Contract
• Swaps Derivative Contract

Example of Derivatives

A simple example might provide a better understanding. Suppose a trader wants to buy 200 stocks of Microsoft next month. To avoid financial risk, a private contract is signed between the trader and the seller party. In that contract, an estimated price is fixed at the time of contract and even if the price increases, the trader pays the same amount for the stocks.

Forward Derivative Contract

Now the estimated price depends on future price expectation. If the price is expected to increase in future, the estimated price will be kept higher than the current price. On the other hand, if the price is expected to decrease in future, the estimated price will be decided lower than the current price. Thus, contract price is dependent on current price and future expectation. This type of derivative is termed as forward derivative contract which is widely used across industries to control financial risks.

To know more about derivatives and its usage in business in order to control and manage financial risk, you can explore our online training on financial modeling courses. Simplilearn offers both online and classroom training courses for FRM Part 1 Exam preparation.