Question

in the Spring you plant your crops and you invest all your time and effort in the crops until harvest in the late Fall. The profit you derive from selling your crops is how you live until the next harvest. If you plant all corn in your fields and so does everyone else, when harvest comes the market is flooded with corn and has nothing else to sell to customers, so the price of corn drops like a rock and all other items rise sky high.

If you have a future’s market you can see how speculators and other farmers are planning their crops due to the future’s prices. A speculator is trying to make money and a farmer is trying to cover the potential loss of their profits from selling their items by purchasing future’s contracts for other items. The idea with this is to hedge your bets on your crop profits with financial profits to cover your expenses.

Please explain the role of futures, forwards, swaps and options within the context of Financial Institution risk management. What limitations should be exercised when FIs participate in utilizing these hedging tools (futures, forwards, swaps and options)?

Answer 1

Futures, forwards, swaps and options are the major types or examples of Derivatves that are used by Financial Institution for risk mangement. A derivative is a financial instrument with a price that is derived from the underlying asset like stocks, bonds, or futures. It is a contractual agreement between two parties in which one party is obligated to buy or sell the underlying security and the other has the right to buy or sell the underlying security.

Derivatives are sometimes used to hedge a position (protecting against the risk of an adverse move in an asset) or to speculate on future moves in the underlying instrument. Hedging is a form of risk management that is common in the stock market, where investors use derivatives called put options to protect shares or even entire portfolios. A put option is an example of a derivative that is often used to hedge or protect an investment. Buying or owning stock and buying a put option is a strategy called the protective put. Investors can protect gains of a stock that has increased in value by purchasing a put. A holder of a put option is under no obligation to exercise the contract and it is often better to sell the put rather than to exercise it, but the seller (the other side of the options contract) of a put option has an obligation to take delivery of the stock if assigned on the put. A call option gives the owner the right but not the obligation to buy shares of stock per contract. A put option, on the other hand, is a contract that gives the holder the right to sell shares of stock. Put options are often used to protect stock holdings or portfolios.

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price. Futures contracts allow producers, consumer, and investors to hedge certain market risks. For instance, a farmer planting wheat today may sell a wheat futures contract now. He will then buy it back come harvest when he sells his wheat - effectively locking in today's price and hedging away market fluctuations between planting and harvest. Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits. Because futures contracts often require actual delivery of the underlying at expiration, hedgers must be sure to exit or roll over positions before expiry. Forward is also similar to Futures in these things and the difference is that it is customized and and futures is standardized.

A swap, in finance, is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The currency swap market is one way to hedge that risk. Currency swaps not only hedge against risk exposure associated with exchange rate fluctuations, but they also ensure receipt of foreign monies and achieve better lending rates. Considered to be a foreign exchange transaction, currency swaps are not required by law to be shown on a company's balance sheet the same way a forward or options contract would. Many currency-hedged ETFs and mutual funds now exist to give investors access to foreign investments without worrying about currency risk.