Inspiria Knowledge Campus

BBA AT & A 602 - FINANCIAL DERIVATIVES

“Advantages and Limitations of Financial

Derivatives”

“A Comparative Analysis with Other Risk

Management Techniques”

Submitted by - Satyam Chhetri

Registration No -213442051410042 (2021-2022)
Roll No. - 34451421031
Introduction
Financial Derivatives are Financial Instruments that are
linked to a specific financial instrument or indicator or
commodity, and through which specific financial risk
can be traded in financial markets in their own right.

Transactions in financial derivatives should be treated

as seperate transactions rather than as integral parts
of the value of underlying transactions to which they
may be linked.

The value of financial derivative derives from the price

of an underlying item, such as an asset or index.

Financial Derivatives are used for a number of

purposes including risk management, hedging,
arbitrage between markets, and speculation.
Financial Derivatives

Unlike debt instruments, no principal amount is advanced to

be repaid and no investment income accrues.

Financial derivatives enable parties to trade specific financial risks (such as interest rate risk,
currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more
willing, or better suited, to take or manage these risks—typically, but not always, without trading
in a primary asset or commodity.

The risk embodied in a derivatives contract can be traded either by trading the contract itself,
such as with options, or by creating a new contract which embodies risk characteristics that
match, in a countervailing manner, those of the existing contract owned. This latter is termed
offsetability, and occurs in forward markets.

Financial derivatives contracts are usually settled by

net payments of cash.
Importance of Risk Management
in Financial Decisions

Risk management in financial decisions is crucial for several reasons. It helps identify
and assess potential threats to financial goals, allowing for informed decision-making.
By understanding and mitigating risks, individuals and organizations can safeguard
investments, ensure financial stability, and enhance the overall success of their financial
strategies. Effective risk management also aids in protecting against market volatility,
regulatory changes, and unexpected events, reducing the likelihood of financial losses
and promoting long-term financial health.
Overview of Financial Derivatives
Financial derivatives are contracts whose value is derived from an underlying asset, index,
rate, or other financial instrument. They serve as risk management tools and can be used for
speculation. Here are common types:

Options: These give the holder the right, but not the obligation, to buy (call option) or sell (put
option) an asset at a predetermined price before or at expiration.

Futures Contracts: These obligate the buyer to purchase, or the seller to sell, an asset at a
predetermined future date and price. Common in commodities and financial markets.

Swaps: These involve the exchange of cash flows or other financial instruments between two
parties. Common types include interest rate swaps and currency swaps.
Examples of Financial Derivatives...
Options: An investor buys a call option on a stock, giving them the right to buy it at a
specified price within a specified time.

Futures: A farmer enters into a futures contract to sell a certain amount of crops at a
predetermined price before the harvest.

Swaps: A company with a variable interest rate loan may enter into an interest rate swap
to convert it to a fixed-rate payment.

These derivatives play a vital role in managing risk, hedging against price fluctuations,
and providing flexibility in financial markets.
Advantages of Financial Derivatives
Hedging Capabilities

Liquidity and
Market Depth Advantages
Enhanced Flexibility in
Risk Management

Potential for
Efficient Price Discovery
Leveraging Returns

While these advantages can enhance financial strategies, it's important to note that derivatives also involve risks, and
misuse can lead to substantial losses. Prudent risk management is crucial when engaging in derivative transactions.
 Advantages
Hedging Capabilities: Derivatives provide a means to hedge against potential losses due to
fluctuations in the value of underlying assets. This risk mitigation is crucial for businesses and
investors looking to safeguard their financial positions.
Enhanced Flexibility in Risk Management: Derivatives allow for tailored risk exposure by providing flexibility in
designing strategies. Investors can customize positions to suit their risk tolerance and market outlook.
Efficient Price Discovery: Derivatives markets contribute to efficient price discovery by reflecting market
expectations and sentiments. The pricing of derivatives incorporates information and expectations, aiding in the
establishment of fair market values for underlying assets.
Potential for Leveraging Returns: Derivatives enable investors to gain exposure to assets without the need for
significant upfront capital. This potential for leverage allows for the amplification of returns, though it also
involves higher risk.

Liquidity and Market Depth: Derivatives markets often exhibit high liquidity and deep markets. This
liquidity facilitates easy buying and selling, providing market participants with the ability to enter or
exit positions more efficiently.
Limitations
Complexity and Learning Curve: Derivatives often have intricate structures and pricing mechanisms, leading to a
steep learning curve for those unfamiliar with these instruments. The complexity can pose challenges for
effective and informed decision-making.
Counterparty Risk: Derivatives transactions involve counterparties, and there's a risk that one party may default
on its obligations. This counterparty risk can be significant, especially in over-the-counter (OTC) markets where
transactions are not standardized and cleared through a centralized exchange.

Market Risk and Volatility: Derivatives are sensitive to market movements and can be highly affected by
changes in asset prices, interest rates, or other market factors. Increased market volatility can lead to
unpredictable outcomes and potential losses.

Regulatory Considerations: The regulatory environment for derivatives is complex, and changes in regulations
can impact the use and availability of certain derivative instruments. Compliance with regulatory requirements
is crucial and adds an additional layer of consideration for market participants.

Understanding these limitations is essential for investors and businesses to make informed decisions, manage
risks effectively, and navigate the dynamic landscape of financial derivatives.
Comparison with Other Risk Management Techniques

Financial Derivatives

Strengths Weakness

Effective for targeted risk management, allowing precise hedging against

Complexity and potential for misuse require a good understanding.
specific exposures.

Enables leveraging and potential for enhanced returns. Counterparty risk can be a concern in OTC transactions

Offers flexibility in designing risk management strategies. Sensitivity to market volatility may lead to unexpected outcomes.
Comparison with Other Risk Management Techniques

Insurance as a Risk Management Tool

Strengths Weakness

Provides straightforward protection against specified risks.

Limited flexibility in customizing coverage to specific needs.

Stable and predictable premiums facilitate budgeting. Premium costs can be high, especially for comprehensive coverage.

Typically covers a broad range of risks, depending on the policy. Coverage may have exclusions or limitations.
Comparison with Other Risk Management Techniques

Diversification Strategies

Strengths Weakness

Spreads risk across different assets or investments. Does not eliminate individual asset risk.

Can provide a more stable overall portfolio performance.

Market-wide events can still impact diversified portfolios.

Lower correlation among diversified assets may reduce overall risk. Overemphasis on diversification may lead to missed opportunities.
Comparison
Precision in Risk Management: Derivatives offer precise hedging,
while insurance and diversification provide broader risk coverage.

Cost and Premiums: Derivatives and diversification often involve

lower ongoing costs compared to insurance premiums.

Flexibility: Derivatives provide high flexibility in tailoring risk

strategies, whereas insurance offers standardized coverage.

Simplicity: Insurance is straightforward, while derivatives can be

complex, and diversification requires thoughtful asset allocation.

Counterparty Risk: Derivatives involve counterparty risk, whereas

insurance typically doesn't face this concern.
 Conclusion
Choosing the most suitable approach depends on the
specific risk exposure, financial goals, and risk tolerance
of the individual or organization. Often, a combination of
these risk management techniques is employed to create
a well-rounded risk mitigation strategy.
Thank You