Risk Management with derivatives
Geir Høidal Bjønnes
• Learning objectives:
What is a derivative?
What is the role of Derivatives and Derivatives Markets
Firms’ risk exposures
Hedging price risk with derivatives
• McDonald: Chapter 1
• Consider a farmer that grows wheat and is expecting to
yield 10,000 bushels of crop in 3 months. He is afraid that
the price of wheat might drop at the period of harvest and
would like to insure against this risk.
• Consider also a baker that buys and stores wheat every
year during the harvest period. He faces the risk that the
price of wheat might increase during that period and
would like to hedge against this risk.
• The farmer and the baker agree to enter into the following contract:
In 3 months from today the baker will buy from the farmer
10,000 bushels of wheat for $5 per bushel.
• The actual price of wheat may be below or above $5 in 3
months. The contracts acts an insurance against this price
What is Risk?
• We dislike uncertainty because we fear the possible
• In order to quantify risk we need to know for each adverse outcome:
– Its cost and
– Its probability
• There exist several measures of risk, e.g. volatility
(variance/standard deviation of the return on an asset)
• Risk is unavoidable whatever it is that we try to do
• In several occasions we can do something to decrease the amount of risk we bear:
– Act in a way that the amount of risk is less
– Give out part or all of the risk to another party
• In a risk management decision we compare the cost of
decreasing the risk with the cost of the risk that we
decrease and then make the decision
Diversifiable vs non-diversifiable risk
• Diversifiable risk: unrelated to other risks. If many
investors share a small piece of such risk, then there is no significant risk left to anyone.
• Non-diversifiable risk: does not vanish when spread across many investors.
• Financial markets permits diversifiable risk to be shared, and non-diversifiable risk to be born by those most willing
to hold it.
Main Use of Derivatives
• The use of derivative securities arises naturally out of the need to manage risk because derivative securities allow the
risk (and other) characteristics of a financial instrument or a financial or other quantity to be separated and managed
– Derivatives similar to insurance policies provide payoffs that depend on other financial or non-financial quantities
A derivative is a financial instrument (or an agreement
between two people) that has a value determined by the
price of something else
Enterprise Risk Management
• Risk management in a company can potentially increase
significantly the value of the company if done correctly
• Risk management process:
Identify the objective of the management team
Identify all risk-factors that affect the objective
Measure the risk of each risk-factor and the total risk
Find ways to control risk:
→ Insurance, Diversification and Hedging
5. Make the optimal risk management decisions
6. Evaluate practices
Much easier said than done!
• A bank may be expected to use interest rate derivatives, currency derivatives, and credit derivatives to manage risk
• A manufacturing firm that buy raw goods and sell products on a global market might benefit from commodity and
Elements of a Derivative Instrument
1. Contract: A contract is agreed upon today and determines the terms of a transaction that will (or might) occur in the future 2. Counterparties: The contract is a binding agreement between two counterparties.
3. Underlying: The transaction involves an “underlying” quantity that can be...
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