Derivative and risk management

A company faces several kind of risk.Unanticipated change in selling price,cost taxes,demand,interest rate technology fluctuated profitability of a firm.Sometime managers are not able to reduce risk.They try many strategies.All financial difficulties and risk can reduce their risk entering into financial contracts.

Risk hedging by derivatives 

The topic will explain what is derivatives and how to hedge risk by it.Derivatives mans those items that do not have their own independent value it is a financial instrument derived from some other asset which is called underlying asset. In the firm risk always remain firm can avoid cash flow fluctuation by reducing the risk.Itwill increase value of their asset or investment.Firm always seeking the way to reduce risk derivative are tools to reduce a firm’s risk exposure.

Firm risk can hedge by four derivatives these are future,forward,option and swap.

Hedging by option

Option is one of  the most complex financial instrument.Firm can use option to minimize risk.Option has two type call option and put option.If a firm purchase new product in large quantity most of firm’s capital invested.In this type of deal always risk remain,to reduce risk firm can buy option in stock market only premium have to pay if strike price more than spot price firm will make profit but unfortunately if price opposite each other firm will loose option premium amount.

Hedging by forward

Forward contract is non-standardized contract between two parties.In this contract assets buy or sell in future at predetermined price.Forward contracts are similar to option in hedging but there is a difference both buyer and seller are bounded by the contract both must have exercise the contract at the agreed price on the specified due date forward contracts are flexible suits the need of buyer and seller.We can enter into a forward contract for any good commodities and asset.We can choose any delivery date and quantity of goods. 

Hedging by future 

Future contract are same as a forward contract.Future contracts are not different from forward contracts.The difference is in terms of standardisation and method of operation.Future contracts have standardised contract size and they trade only the organised exchanges.In future contract both parties should agreed as same price,duedate and time.In future contracts like in the forward contracts one party will loose and other will gain.

Hedging by swap

Swap are same as future and forward contracts.It is also providing hedge against risk.Swap also a agreement between two parties called counter parties most popular swap are currency swap and interest rate swap.This two swap can be combined when interest on loan can be swapped between two currency.

1)Currency swap :- In currency swap exchange of cash payment done between two currency most of companies want overseas investment but they find difficulties entering in new market currency swap is an alternative to overcome this problem.

2)Interest rate swap:-The interest rate swap allows a company to borrow capital at fixed and exchange its interest payment at floating rate or fixed rate LIBOR is the market determined interest rate for banks to borrow from each other in the euro dollar market.

 

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