Use of Derivatives in Risk Management Term Paper

Use of Derivatives in Risk Management - Term Paper Example Following are the major sorts of instruments applied by organizations to manage the financial risks associated with business activity. Futures and Options In this type of instrument, one individual or business signs a contract with another one to purchase the commodity on some future date with an agreed-upon price. However, in futures both of the parties have to go through with the contract while in options both of the parties reserve the right to withdraw the contract upon paying in monetary terms. Agreements: This instrument is localized in nature, and governments do not interfere with its transactions. Nevertheless, the purpose of these agreements is the same as that of futures and options, which is to hedge against fluctuations in the market price of the commodity or an industrial product. It is also important to note that these kinds of agreements are more common in economically distressed nations. But, recently they are intensively deployed in order to ensure a supply of raw material in US, which is necessary because of the prevailing recession in the local market. So, it is safe to assume that businesses are preparing themselves for increasing adversities of the future by contracting with their suppliers on a long term basis, which also enables them to attain economies of scale as a result, driving their financial and operational costs down that allows them to lower their prices in order to increase their market share. Nevertheless, it is fascinating to acknowledge that various businesses are paying close attention towards managing financial risk through using statistical models in order to assess the current level of risk, which can disrupt the expected pattern of their cash flows (Benson & Oliver, 2004). However, they often lack the proper translation of this analysis into practical plans, so in this way they cannot benefit from the concept of derivatives effectively most of the times. On the other hand, manufacturing sector of Europe is using derivatives more extensively than American ones (SpricIc, 2007). The prime reason for this trend is prevailing and growing uncertainty of the European market as compared to that of America. Along with this, managers who deploy derivatives in order to evaluate the degree of risk in financial terms are viewed as trustworthy by stockholders because they consider it as the proper and desirable means of minimizing financial threats (Koonce, Lipe, & McAnally, 2008). However, managers are found to falter by not basing their business decisions on the results of derivative analysis, therefore portraying the image of rational business decision making when in reality it is not the case. At the same time, derivatives are not rated as an effective mean for minimizing the possibility of default (Yi, Lin, & Chen, 2008). Therefore, derivatives can only be utilized as the mean of predicting future financial position of a particular firm. However, it is important to note that firms that base their decisions on derivative analysis often outperform those that do not consider derivatives as an ideal method for predicting financial future (Lin, Pantzalis, & Park, 2009). Another advantage of successful risk management is contentment of stockholders (Berk, Peterlin, & Cok, 2009). Through effective management, risk managers can handle them and are