Risk management and the use of derivatives

This paper investigates the use of derivatives in Risk Management. Deriving the value from an underlying asset or an index representing assets, derivatives bear the ability to accelerate gains or losses for a small initial outlay thus assisting corporations to manage risk and return opportunities, while adding value to their operations.

Keywords: risk, forwards, futures, options, hedging, speculation, arbitrage.

[...] This changed the concept of Risk Management radically, making it increasingly important. Focusing on matters of insurance, Risk Management aims to identify potential risks that may be serious potential threats to the organization. Modern organizations use Risk Management as a common practice, particularly for any operation, which is related to financial or facilities management. However, Risk Management is not focused only on financial risks, but on a multitude of risks that may pose potential threats for the organization. In particular, some of the risks, which need to be alleviated or managed by Risk Management, are: Financial risks They are related to financial transactions. [...]

[...] Deriving the value from an underlying asset or an index representing assets, derivatives create a wide range or risk and return opportunities for investors. A derivative can be defined as a financial instrument, whose value is derived from the values of other underlying variables, which, in most cases, are the prices of the traded asset (Hull, 2006). Derivatives are traded since 1848 on the Chicago Board of trade (CBOT, www.cbot.com) to bring farmers and merchants together and standardize the quality and quantity of the goods exchanged. [...]

[...] By providing unlimited leverage, derivatives actually demand a liquidity that far exceeds the market’s potential, especially on difficult days and may also go beyond the abilities of the central banks to maintain orderly conditions. Getting volatility assumptions wrong is a major risk management failure. Volatility smile refers to the degree to which an option pricing model can display the probability of extreme moves, when there is little trading information available, either, because the specific options are traded rarely or because they have long maturity (Shirreff, 2004). [...]