DERIVATIVES FOR MANAGING

FINANCIAL RISK
 LEARNING OBJECTIVES
 Understand the reasons for hedging

Show how options can be used to hedge risk

Explain forwards’ and futures’ contracting

Illustrate use of future and forward contracts for hedging risk

Discuss use of swaps to change the risk of interest rates and

currencies

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Derivatives and Risk Hedging
A derivative is a financial instrument whose pay-offs is derived
from some other asset which is called as an underlying asset.

There are a large number of simple derivatives like futures or

forward contracts or swaps. Options are more complicated
derivatives.

Derivatives are tools to reduce a firm’s risk exposure. Hedging is

the term used for reducing risk by using derivatives.

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FORWARD CONTRACTS
A forward contract is an agreement between two parties to
exchange an asset for cash at a predetermined future date for a price
that is specified today.

In case of a forward contract, both the buyer and the seller are
bound by the contract while under an option, the buyer has a right to
decide whether or not he would exercise the option.

Forward contracts are flexible. They are tailor-made to suit the

needs of the buyers and sellers. Foreign currencies forwards have
the largest trading.

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 FUTURES CONTRACTS
Future contracts are forwards contracts traded on organised exchanges in
standardised contract size. For example, the standard contract size for barley in
the barley international exchange is 20 metric ton.

The short hedge is a common occurrence in business, and it takes place

whenever a firm or an individual is holding goods or commodities(or any other
asset) or is expecting to receive goods or commodities

Generally, a long hedge occurs when a person or the firm is committed to sell
at a fixed price.

Unlike options but like forward contracts, future contracts are obligations; on
the due date the seller(farmer) has to deliver barley to the buyer(miller) and the
buyer will pay the seller the agreed price. In the futures contracts, like in the
forward contracts, one party would lose and another will gain.
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Financial Futures
Financial futures, like the commodity futures, are contracts to
buy or sell financial assets at a future date at a specified price.

Financial futures, introduced for the first time in 1972 in USA,

have become very popular. Now the trading in financial futures far
exceeds trading in commodity futures.

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 Futures Contracts Vs. Forward Contracts
Organised futures exchanges

Standardised contracts

Margin

Marked to market

Delivery

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 Hedging a Future Payment With a Forward Contract

1,750,000 Unhedged Cost of £ 1 Million Payment

P
1,740,000 Forward Contract Gain
a
y 1,730,000
m
1,720,000
e
1,710,000 Forward
n Contract Loss
t 1,700,000

C 1,690,000
o 1,680,000
s
1,670,000 Forward Rate
t
1,660,000
1,650,000
1.65 1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 1.76

Dollar Value of Pound in 90 Days

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RISK HEDGING WITH OPTIONS
An option is a right to buy or sell an asset at a specified exercise
price at a specified period of time.

Foreign currency option is a handy method of reducing foreign

exchange risk. Similarly, options on interest rates and commodities
are quite popular with managers to reduce risk.

Many options trade on option exchanges. However, in practice,

banks and companies strike private option deals.

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 HEDGING IN CRICKET MATCHES

Rates Favourite Your Bet Lahore Karachi

.84-.86 Karachi Lahore 20000 -17200

Net 20000 -17200
.92-.94 Karachi Lahore 10000 -9400
Net 30000 -26600
.45-.47 Lahore Karachi -35250 75000
Net -5250 48400
.56-.58 Lahore Lahore 28000 -50000
Net 22750 -1600
.53-.55 Lahore Karachi -8250 15000
Net 14500 13400
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 Rates Favourite Your Bet Lahore Islamabad

.14-.16 Lahore Islamabad -8000 50000

Net -8000 50000
.47-.49 Lahore Lahore 9400 -20000
Net 1400 30000

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 Contract Size : DM 62,500
Exercise Price : $0.64 per DM
Option Premium : $ 0.02 per DM ($1,250 per contract)
Expiration Date : 60 days Potentially
P 2500
Unlimited Profit
R 1875
O
F 1250 Exercise Price
I
T 625

$0.60 $0.62 $0.64 $0.66 $0.68 $0.70

-625 Spot Price of DM at Expiration
L Limited Loss
O -1250 Break Even Price
S
Call Premium
S -1875

Profit from Buying a Call Option for various Spot prices at Expiration
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 Contract Size : DM 62,500
Exercise Price : $0.64 per DM
Option Premium : $0.02 per DM ( $1,250 per contract )
Expiration Date : 60 days
P 2500
R 1875
O Potential Exercise Price
F 1250 Profit up to
I $38,750
T 625 Spot Price of DM at Expiration

$0.58 $0.60 $0.62 $0.64 $0.66 $0.68

-625
L Breakeven Price Limited Loss
O -1250
S
Put Premium
S -1875

Profit from Buying a Put Option for Various Spot Prices at Expiration
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SWAPS
A swap is an agreement between two parties, called counter parties, to trade
cash flows over a period of time.

Two most popular swaps are currency swaps and interest- rate swaps.

Currency swap involves an exchange of cash payments in one currency for

cash payments in another currency.

The interest rate swap allows a company to borrow capital at fixed(or

floating rate) and exchange its interest payments with interest payments at
floating rate(or fixed rate).

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USES OF DERIVATIVES

The objective of firms using derivatives is to reduce

the cash flow volatility and thus, to diminish the
financial distress costs.

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