Futures, options, swaps and even forward contracts are viewed as the main forms of derivatives. Since development of swaps in the 1980s, the two main swap contracts in the financial sector are currency and interest-rate swaps. The methodology of interest rate swaps involves an over the counter (OTC) derivative in which there is an agreement between two parties to exchange interest rate cash flows. If a firm wishes to reduce its exposure to interest rate sensitivity, then the best contract would be to pursue an interest rate swap.
With an interest rate swap contract, for example, the payments of a flow rate of interest may be agreed in exchange for a fixed rate of interest. As a result, the value of assets and liabilities are unaffected and thus the position is hedged. So, the floating rate of interest payments can be exchanged for a fixed rate of interest (and vice versa). Interest rate swaps are essential when it comes to risk management, as the contract can be used to hedge, speculate and manage risks. Any volume of floating and fixed interest rate exposures are cancelled out, with interest rate swaps offsetting any remaining interest rate risk.
The relationship between derivatives and risk management is relatively simple. Derivatives are seen as the tool that enables banks and other financial institutions to break down risks into smaller elements. From this, the elements can be bought or sold to align with the risk management objectives. So, the original purpose of derivatives was to hedge and spread risks. The main motive of the financial tool has aided with the great development and expansion of derivatives. For instance, in order to overcome interest rate risk, an alternative to total return swaps was created, that is credit default swaps (CDSs).
CDSs are unique, as they transfer the risk of default from the holder to seller of a fixed income security. If the CDS loan defaults, the seller will have to pay for the loss through a payment that is equal to the value of the original loan minus the secondary market value of the defaulted loan. The increase in trading of CDS has led to a transfer of credit risk from banks to insurance companies. So, credit default swaps are useful for risk management, as it is a tool for hedging risks. Along with insurance corporations, hedge, mutual and pension funds are the net sellers of credit protection. However, the financial crisis of 2008 has dampened the reputation of credit default swaps significantly.
Derivatives have revolutionised the management of risk within the financial world. The tool has allowed unwanted risks to be sold off, with the efficient management of risks that wish to be kept. Financial derivatives allow specific risks to be targeted and dealt with as well as used for hedging against unwanted risk. The instrument has become so important that a firm is at a greater risk if they do not use derivatives. Market efficiency can be improved, as the financial instrument allows risks to be sold onto those that are willing to accept them, i.e. insurance firms. At the same time, if there is a poor structure of risk management within a financial corporation then derivatives begin to become dangerous for managing risk. If derivatives are not fully understood, then the instrument may start to pose financial threats.
Original article by Daniyal Rehman