Excellent description of forward contracts. Forward contract can be for currency exchange, supply chain, commodity prices, and more. Merna, AL-Thani (2008, p 222) “In response to the increased foreign exchange risk, the market provided forward contracts on foreign exchange, foreign exchange futures (in1972), currency swaps (in 1981), and options on foreign exchange (in1982).” This strategy provided some risk mitigation as we expanded into the global economy.In addition to the existing forward contracts for metal and long-term contracts for petroleum, the onset of the increased price volatility in the late 1970s led to the appearance of futures contracts for commodities.These were followed by commodity swaps (in 1986) and commodity options in 1986.
These same contracts as you have stated can be used for hedging to reduce risk. What specific examples can anyone present?
In many cases derivatives are more like a scale that balances the risk or reduces uncertainty. Consider a mutual fund that relies on the profits of the real-estate market and we want to protect against the down sides of the real-estate bust. We may invest in a derivative that makes profit on loan defaults. As the one fund decreases in value the other would increase. This would reduce uncertainty in your real-estate business. Both accounts may make money that is why they are in business but when one is losing the other may be gaining. Companies can further reduce risk by pooling these funds into portfolios that are similar in risk or industry to manage those risks.This is a more likely scenario in the purchase of derivatives for the purpose of hedging, i.e. hedge funds. Derivatives serve other purposes such as future contracts to manage capacity planning for say a refinery. A manufacture or refinery is most efficient when running at 97% – 100% capacity future contracts can help with that.
Can anyone think of other uses or examples of derivatives? Can anyone provide examples of hedge funds to reduce uncertainty?
Some of the challenges with risk mitigation are the cost above the value of the contacted price. Hedging, a way of offsetting risk, using derivatives can be challenging to calculate.They tried to hedge their exposures to these products by taking positions in other
derivatives, which didn't work. The hedges were hard to calculate and they didn't calculate them right. And the difficulties were magnified by the fact that a number of players found themselves in the same situation and tried to leave at the same time. It's known as a 'rush to the exits' or a 'crowded trade.' (Futures: News, Analysis & Strategies for Futures, Options & Derivatives Traders
This is a specific example of challenges with risk management and derivatives. What comments does anyone have on this example? How would you use this in risk maangment?