Application of Derivatives for Risk Management & Speculation

(Leveraging)
Derivatives play an integral role in helping companies manage risk and are
likely to occupy an increasingly prominent place at firms that are seeking
shelter from the volatility of the financial markets. Derivatives have sound
economic and commercial benefits, and have been and remain necessary to the
development of trade and commerce, but the manner in which they are used can
pose a risk to the system.
Derivatives allow the sharing or redistribution of risk. They can be used to
protect (hedge) against a specific exposure of a business (e.g. movements in
asset price, exchange or interest rate, default of a creditor) or can be used by
market participants to take on risk and speculate on the movement in the value
of underlying assets, without ever owning the assets.
Derivatives can allow businesses to manage effectively exposures to external
influences on their business over which they have no control. An example of
this type of usage was provided by British Airways. Aviation is particularly
exposed to fuel prices, with 32% of BA's operating expenditure spent on fuel in
2009. As the price of fuel can vary considerably, BA hedges this exposure
through the use of derivatives, which allows the company to focus on its core
business (pp 68-9). By taking out a futures derivative to purchase some of its
fuel in advance of its receipt at a fixed price, they are protected against an
increase in fuel prices. If prices fall below the level set in the contract, the loss
made on the derivatives contract is offset by the lower cost of fuel that they buy
in a conventional manner.
Some market operators have been criticised for using derivatives purely as tools
for speculation. A derivatives contract involves one party reducing its risk, and
the other taking on risk associated with an underlying asset. This allows parties
to speculate on the values of underlying assets, without necessarily having any
actual interest in the asset itself. This use of derivatives for speculating on
prices, coupled with the lack of transparency in the derivatives market as a
whole, can lead to parties taking on too much risk and potentially destabilising
the financial system.
Derivatives have an important economic function, namely redistribution of risk,
but some forms of derivatives can be used as tools for speculation by
participants in the financial market who have ownership of the underlying asset.

Coupled with a lack of transparency in the market, where build-ups in risk

cannot be detected by actors or supervisors, derivatives could help destabilise
the financial system, particularly if there is a significant shift in the value of
underlying assets.

Applications

of

derivatives

for

hedging

and

speculation

Derivatives, like most tools, are neutral until utilized. It is with utilization that
positive and negative attributes can identified. The main utilization issue related
to the use of derivatives is the use to which management is applying derivative
strategies - hedging or speculating. Hedging is generally perceived to be good
and speculating is generally perceived to be bad. However, there are three
thoughts that should be kept in mind when considering these generalizations:
1. Hedging rationale and the related documentation is oftentimes cleverly
utilized to disguise speculation. Therefore, the real issue is how to
properly distinguish hedging from speculating. This is more difficult than
it would appear. Many would point to a textbook description to describe
an appropriate hedge. Textbook descriptions are just that. They are used
to illustrate hedging concepts and principles. Real time implementation,
under changing market conditions, has considerably more imperfections
than what can be adequately described in a textbook illustration.
However, these imperfections are not justification for speculating. They
are simply an additional risk that management must learn how to manage.
The key to distinguishing between hedging and speculating rests in
management's discipline in consistently applying the precepts outlined in
the foregoing risk management process discussion.
2. Speculation is an inherent part of human behavior and when managed
properly can produce very constructive results. However, some entities
are precluded, by regulations or internal policies and procedures, from
speculating with derivatives. The paradox of this is that these same
entities, for the most part, are allowed to speculate through policy
decisions and cash market transactions. And, furthermore, are, in effect,
speculating when they are not hedged. Therefore, the issue becomes one
of knowing when and how to properly speculate as a function of the

business and regulatory environment within which the management

activity is taking place.
3. Regardless of whether management is hedging or speculating, there is
one very dominant consideration inherent in both - prudent management
of the risks associated with the underlying activity.

Difference between Forward contract and Futures Contract.

Forward Contract

Future Contract

Definition

A forward contract is an
agreement between two parties
to buy or sell an asset (which
can be of any kind) at a preagreed future point in time at a
specified price.

A futures contract is a
standardized contract,
traded on a futures
exchange, to buy or sell
a certain underlying
instrument at a certain
date in the future, at a
specified price.

Structure & Purpose

Customized to customer
needs. Usually no initial
payment required. Usually
used for hedging.

Standardized. Initial
margin payment
required. Usually used
for speculation.

Transaction method

Negotiated directly by the

buyer and seller

Quoted and traded on

the Exchange

Not regulated

Government regulated
market (the Commodity
Futures Trading
Commission or CFTC is
the governing body)

The contracting parties

Clearing House

Market regulation

Institutional guarantee

Risk

High counterparty risk

Low counterparty risk

No guarantee of settlement
until the date of maturity only
the forward price, based on the
spot price of the underlying
asset is paid

Both parties must

deposit an initial
guarantee (margin). The
value of the operation is
marked to market rates
with daily settlement of
profits and losses.

Forward contracts generally

mature by delivering the
commodity.

Future contracts may

not necessarily mature
by delivery of
commodity.

Expiry date

Depending on the transaction

Standardized

Method of pretermination

Opposite contract with same

or different counterparty.
Counterparty risk remains
while terminating with
different counterparty.

Opposite contract on the

exchange.

Standardized

Contract size

Depending on the transaction

and the requirements of the
contracting parties.

Market

Primary & Secondary

Primary

Guarantees

Contract Maturity