DERIVATIVES FOR MANAGING FINANCIAL RISK
Q-1 What are derivatives? Why do companies hedge risk using derivatives? A-1 A derivative is a financial instrument whose pay-offs is derived from some other asset which is called an underlying asset. Option, an example of a derivative security, is a more complicated derivative. There are a large number of simple derivatives like futures or forward contracts or swaps. Derivatives are tools to reduce a firm's risk exposure. A firm can do away with unnecessary parts of risk exposure and even convert exposures into quite different forms by using derivatives. Hedging is the term used for reducing risk by using derivatives. There are several advantages of better risk management through hedging: Debt capacity enhancement
Increased focus on operations
Isolating managerial performance
Q-2 How can options be used to hedge risk? Illustrate your answer. A-2 An option is a right to buy or sell an asset at a specified exercise price at a specified period of time. Option is a right and does not constitute any obligation on the part of the buyer or seller of the option to buy or sell the underlying asset. A 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 Let us consider an example. Suppose ONGC sells oil to Indian Petrochemical Limited (IPCL). ONGC wants to protect itself from a potential fall in oil prices. What should it do? It should buy a put option - a right to sell oil at a specified exercise price at a specified time. ONGC will be able to protect itself from falling prices and at the same time benefit from increase in the oil prices.. Q-3 Define forward and future contracts? What are the differences between forward and future contracts? A-3 A forward contract is an agreement between...
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