Question

What are the four basic types of contracts or instruments used in financial risk management?

Answer 1

Derivatives are contracts which are used to manage risk .

The four types of instruments for managing financial risks are:

• Forwards
• Futures
• Options
• Swaps

Futures are standardized contracts and are traded on the exchange. Here, the clearing house acts as an intermediary and protects both the parties against the losses

Forwards are customized contracts . These contracts carry a credit risk as the clearing house is not present as an intermediary between the two parties.

Options are instruments which provide a right but but an obligation to the holder to  buy a certain asset.

Swaps are derivative contracts between two parties to exchange cash in the future. Interest rates swaps and currency swaps are the two most popular swaps available in the market.