Question

a)- From the time period of 1970 and more significantly in 1980s & 1990s, the financial institutions are seriously facing growing market risks. Given the greater need for risk reduction, financial innovation came to assist financial institutions by offering new financial products and services that help financial institution to manage risk in a better way. Briefly define hedging and its role in diversifying risk.

b)- Explain and differentiate the following: Forward Markets, Financial Futures Markets and Options

Answer 1

a) Hedging and its role in diversifying risk.

Risk management has become a dominant factor in contemporary markets. As global markets develop and opportunities expand, so does the need for cautious, effective, and intelligent risk management.

A hedge is an investment to reduce the risk of adverse price movements in an asset. Hedging is a way to ensure against financial risks via taking an offsetting position to the one in an asset. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Locking in a price today allows for better planning for the future without worrying about business risk.

Few reasons to hedge

• To fix consistent and stable cash flows
• To determine/ fix a sale/purchase price of a commodity
• To reduce the existing cash position risk exposure

Ways/Instruments to hedge to reduce risk

• Forward contract
• Futures contract
• SWAP's
• Options

All these instruments help in diversifying risk.

b) Forward, Futures and options

Forward

A forward contract involves an agreement to buy and sell assets at a future date. The price of the contract is derived from an asset like equity, bond, etc. It is an agreement made OTC(Over the counter) between two parties that decide the terms and conditions of the contract. It is settled at the end of the contract date. Because it is an agreement between two parties, the terms and conditions aren't rigid. There is a high counterparty risk i.e., there is a chance that one of the parties (losing) will default.

Futures

Futures are similar in a way to the forward contracts. It also involves an agreement to buy and sell assets at a future date and the price is derived from an asset but the difference is that a Futures contract is a standardized contract with fixed maturity dates and are traded on stock exchanges. They are marked to market daily i.e., settled on a daily basis. As they are traded on exchanges, they have clearing houses that guarantee the transactions. Hence there is no counterparty risk. The market is liquid, investors can enter and exit whenever they want to.

Options

Options are financial instruments that derive their value from an underlying asset. An option gives the buyer a right but not the obligation to buy or sell(depending on the type of option) the underlying asset.

2 types of options

• Call option - allows the buyer of the option to buy the underlying asset at the stated(strike) price.
• Put option -  allows the buyer of the option to sell the underlying asset at the stated(strike) price.

Options are bought and sold through online or retail brokers. Options form a basis for a variety of options strategies designed for hedging.

Options contract involves a buyer and a seller. The buyer pays a premium to the option seller for the right to buy/sell the share. If a person is bullish about the market, he will buy a call option and vice versa.

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