ISSN:
2181-3906
2023
International scientific journal
«MODERN SCIENCE АND RESEARCH»
VOLUME 2 / ISSUE 10 / UIF:8.2 / MODERNSCIENCE.UZ
552
THE ROLE OF FINANCIAL DERIVATIVES IN HEDGING FINANCIAL RISKS
Jahongir Yuldashev
Banking and Finance Academy of the Republic of Uzbekistan
Khоlikоv Khamidulla
Hеad spеcialist, thе Cеntral Bank оf thе Rеpublic оf Uzbеkistan
https://doi.org/10.5281/zenodo.10015094
Abstract.
This article explores the immense importance and relevance of financial
derivatives in the context of minimizing and protecting against potential financial hazards. The
main focus here is to acquire an in-depth comprehension of the crucial role that these instruments
play in mitigating and overseeing risks.
Keywords:
financial derivatives, futures, forwards, options, swaps, financial risk, credit
risk, liquidity risk, operational risk, market risk, legal risk, hedging, risk management.
РОЛЬ ФИНАНСОВЫХ ПРОИЗВОДНЫХ ФИНАНСОВЫХ ФИНАНСОВЫХ
ФИНАНСОВЫХ ФИНАНСОВЫХ ФИНАНСОВЫХ РИСКОВ
Аннотация.
В этой статье исследуется огромная важность и актуальность
производных финансовых инструментов в контексте минимизации и защиты от
потенциальных финансовых рисков. Основное внимание здесь уделяется глубокому
пониманию решающей роли, которую эти инструменты играют в смягчении и контроле
рисков.
Ключевые слова:
производные финансовые инструменты, фьючерсы, форварды,
опционы, свопы, финансовый риск, кредитный риск, риск ликвидности, операционный риск,
рыночный риск, юридический риск, хеджирование, управление рисками.
INTRODUCTION
Financial derivatives are a pivotal component of the contemporary economy, enabling
individuals and companies to manage risks, speculate on price fluctuations, and access diverse
asset classes. By offering a means to stabilize investment portfolios, safeguard against turbulent
market conditions, and enhance financial gains, derivatives serve as a valuable tool for investors
to enhance their overall fiscal resilience.
The growth of the derivatives market has assumed an increasingly significant role within
the realm of finance, functioning not only as a crucial safeguarding mechanism but also as a
valuable source of immediate information, thus enhancing the efficiency of financial market
operations. The derivatives market holds an indispensable position in fostering the progress of
efficient capital markets. It promotes the seamless movement of capital across borders and fosters
greater prospects for portfolio diversification. By enabling and intensifying the accumulation of
capital, the advancement of derivatives markets exerts a notable impact on both the financial
market and economic advancement.
DEFINITION AND TYPES OF FINANCIAL DERIVATIVES
Definition of financial derivatives
ISSN:
2181-3906
2023
International scientific journal
«MODERN SCIENCE АND RESEARCH»
VOLUME 2 / ISSUE 10 / UIF:8.2 / MODERNSCIENCE.UZ
553
There are numerous interpretations and explanations surrounding the concept of financial
derivatives. These definitions may vary based on the context and perspective of various reputable
institutions involved in the financial industry.
The International Monetary Fund defines financial derivatives as “financial instruments
that are linked to a specific financial instrument or indicator or commodity, and through which
specific financial risks can be traded in financial markets in their own right”
[1]
.
The Bank for International Settlements (BIS) provides a similar definition with some
specifications on the types of financial risks for mitigation. According to the BIS, a derivative
contract is “a financial instrument that is linked to another specific financial instrument or indicator
or commodity and through which specific financial risks (such as interest rate risk, foreign
exchange risk, equity and commodity price risks, credit risk and so on) can be traded in their own
right in financial markets”
[2]
.
The Law of the Republic of Uzbekistan “On the securities market” specify derivatives as
“securities issued by legal entities in the form of options, futures on securities, depositary receipts
and other financial instruments that certify the rights or obligations of their owners in relation to
other securities”
[3]
.
Types of financial derivatives
In the field of finance, individuals and companies come across a wide range of financial
derivatives that include futures contracts, forward contract, options and swaps. The classification
of these instruments is based on their unique characteristics and operational aspects that are widely
observed in the extensive financial market landscape.
Futures contracts
A futures contract is a standardized contract in which both parties agree to purchase or sell
the underlying commodity or asset at a predetermined price on a specified future date
[4]
. They
offer a financial tool that allows market participants to effectively manage changes in the value of
an asset within a specific period of time.
The purchaser of a futures contract is required to acquire the underlying asset, while the
seller is obliged to sell it, with both parties following pre-established conditions regarding price
and date. These contracts are actively traded on exchanges, which play a vital role as intermediaries
in facilitating transactions between buyers and sellers
[5]
.
Futures contracts offer two forms of settlement: physical delivery or cash settlement. In the
case of physical delivery, the buyer receives the underlying asset at the predetermined price and
date. Alternatively, cash settlement involves the payment of cash based on the disparity between
the spot price and the futures price of the underlying asset
[6]
.
Forward contracts
A forward contract is a financial tool enabling two parties to decide on the buying or selling
of an asset on a prearranged date, at a present agreed-upon price. This asset may encompass
commodities, currencies, stocks, bonds or real estate
[7]
.
Forward and futures contracts differ in terms of standardization of their specifications and
the manner in which they are traded. Futures contracts are traded on exchanges and follow a set
standard, whereas forward contracts are typically concluded over-the-counter (OTC), implying
that they are customized to meet the specific requirements of the involved parties. Similar to
ISSN:
2181-3906
2023
International scientific journal
«MODERN SCIENCE АND RESEARCH»
VOLUME 2 / ISSUE 10 / UIF:8.2 / MODERNSCIENCE.UZ
554
futures contracts, forward contracts are resolved through the exchange of physical assets or cash
settlement
[6]
.
Options
Options are a form of financial instrument in which the purchaser is granted the choice, but
not the requirement, to purchase or sell an underlying asset at a predetermined price and date.
Exchanges and OTC markets serve as platforms for trading options. These instruments have
diverse applications encompassing hedging, speculation, and generating income
[6]
.
There are two primary categories of options: call options and put options. Call options
provide the purchaser with the right to purchase an underlying asset at a predetermined price,
known as the strike price, by a specified date referred to as the expiration date. On the other hand,
put options grant the buyer the right to sell an underlying asset at a predetermined price on or
before a specified date
[6]
.
There are two types of options based on their maturity, namely American and European
options. The difference between them lies in how flexible they are to exercise. American options
provide the benefit of allowing investors to exercise them at any time before the expiration date,
giving them more freedom in decision-making. Conversely, European options only allow exercise
on the expiration date, limiting investors’ ability to take a prompt action
[8]
.
Based on data provided by the Options Clearing Corporation (OCC), the entity responsible
for ensuring the integrity of all U.S. exchange-traded options, OCC successfully cleared an
unprecedented 10.38 billion contracts in the year 2022, with an average daily volume of 41.3
million contracts
[9]
.
Swaps
A swap contract is a financial instrument that enables the exchange of cash flows associated
with an underlying asset between two entities. The underlying asset may encompass diverse items,
including but not limited to interest rates, currencies or commodities. Upon mutual consensus,
both parties commit to exchanging cash flows for a specified time span, which are determined by
the value of the underlying asset. Swap agreements are designed to meet the unique needs of the
participants, allowing them to employ swaps to mitigate risks, speculate on future prices, or
generate income
[10]
.
There is an extensive selection of swaps available, each designed to counteract a specific
form of risk or to achieve profits by capitalizing on expected future price fluctuations. Among the
plethora of swap options frequently utilized, the following can be highlighted
[11]
:
1.
Interest rate swaps
enable parties to interchange fixed-rate payments with floating-rate
payments, facilitating flexibility and risk management in financial transactions. For instance, a
corporation possessing a loan with a variable interest rate might engage in a swap with another
corporation that holds a loan with a fixed interest rate in order to mitigate its susceptibility to
fluctuations in interest rates.
2.
Currency swaps
provide the opportunity for parties to exchange payments in one
currency for payments in another currency, assisting in mitigating currency fluctuations and
enhancing international trade. For example, a company that holds debt in foreign currency could
engage in a swap agreement with another company that holds debt in domestic currency thus
mitigating its vulnerability to currency fluctuations.
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«MODERN SCIENCE АND RESEARCH»
VOLUME 2 / ISSUE 10 / UIF:8.2 / MODERNSCIENCE.UZ
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3.
Commodity swaps
offer parties the ability to exchange payments linked to the price of a
specific commodity, such as oil or gold, providing a means to manage exposure to commodity
price volatility. An instance of this would be a company that opts to exchange its dependence on
oil prices by engaging in a mutual agreement with another company specialized in oil production.
In this scenario, one party consents to make predetermined payments for each unit of oil and
receive the current market price for it. Conversely, the other party will receive the predetermined
rate and make payments based on the fluctuating price.
4.
Credit default swaps
enable parties to transfer the potential risk of a loan or other
financial obligation default, offering protection and transferring the burden of potential losses to
another entity. For instance, an investor may engage in a swap agreement with an insurance
company, aiming to safeguard his investment from potential financial setbacks in the event of a
specific company’s failure to meet its debt obligations.
FINANCIAL RISKS AND THEIR TYPES
Definition of financial risk
Financial risk can be defined as the potential for loss resulting from inadequate or failed
internal processes, people and systems, or from external events such as market volatility and
liquidity constraints
[12]
.
In the modern world we live in, the importance of financial risk cannot be emphasized
enough due to its crucial role in the global financial system. Financial markets are characterized
by intricate complexity and close interconnections, giving rise to a multitude of factors that impact
the worth of investments and enterprises, consequently amplifying their vulnerability to risks.
Financial risk can exert a consequential influence on individuals, enterprises, and the global
economy as a whole. On an individual level, financial risk has the potential to induce significant
financial adversity, leading to distressing outcomes such as bankruptcy or foreclosure. Similarly,
businesses face the threat of financial risk, which in turn can result in insolvency or bankruptcy.
On a larger scale, the global economy is vulnerable to financial risk, which, if not managed
effectively, can trigger recessions and cause financial crises
[13]
.
Financial risk can manifest itself as a multifaceted instrument, bearing both advantageous
prospects and adverse implications. Individuals possessing a heightened inclination towards risk-
taking may stand to reap substantial rewards from their investments. Nevertheless, it is crucial to
recognize that those same individuals who willingly indulge in immoderate risk-taking may face
the unfortunate repercussion of encountering financial losses
[13]
.
Types of financial risks
There are various types of financial risks that encompass a wide range of potential hazards,
including credit risk, liquidity risk, operational risk, market risk and legal risk. These risks are
associated with the uncertainties and potential losses that can occur in financial transactions and
activities
[14]
.
Credit risk
This form of risk emerges when the borrower encounters difficulties in paying back the
original amount borrowed or the interest associated with a loan. This risk can be subdivided into
two distinct categories, namely default risk and credit spread risk. Default risk pertains to the
uncertainty surrounding a borrower’s ability to fulfill their repayment obligations. On the other
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hand, credit spread risk delves into the difference between the return on an asset deemed to carry
a certain level of risk and the return on an asset that is considered risk-free
[15]
.
Liquidity risk
Liquidity risk is concerned with the difficulty encountered by an investor when they face
challenges in promptly selling their asset that could potentially result in financial losses. This risk
can be classified into two specific types: funding liquidity and market liquidity. The aspect of
funding liquidity revolves around the investor’s ability to access the required funds at a reasonably
affordable cost, whereas market liquidity is centered on the investor’s capability to sell their asset
without inflicting any notable repercussions on its price
[16]
.
Operational risk
Operational risk is the possibility of encountering risks due to deficiencies or failures in
the internal procedures, individuals, and systems of an organization, as well as external events.
This category of risk can be further divided into four distinct groups, namely people risk, process
risk, systems risk and external events risk, each with its own unique characteristics and
implications
[17]
.
People risk specifically pertains to situations where there are shortcomings or failures
within the internal processes that involve individuals within the organization. This could include
issues such as inadequate training or lack of competence among employees, leading to errors or
inefficiencies in the company’s operations. It also encompasses risks associated with poor
employee behavior or misconduct, which could potentially harm the organization’s reputation or
lead to financial losses
[17]
.
On the other hand, process risk is directly related to insufficiencies or failures in the internal
procedures themselves. This could include flaws in the workflow, lack of proper documentation
or controls, or insufficient monitoring mechanisms
[17]
.
Systems risk, as the name suggests, arises when there are inadequacies or failures in the
systems that support the organization’s operations. This includes both technological systems, such
as software, hardware and network infrastructure, as well as non-technological systems, such as
communication channels and organizational structures. When these systems are compromised or
malfunctioning, it can lead to disruptions in the company’s operations, data loss or breaches in
security
[17]
.
Lastly, external events risk emanates from factors beyond the company’s control. These
events can be unpredictable and varied, ranging from natural disasters like hurricanes or
earthquakes that may hinder the company’s shipping process or cause supply chain disruptions, to
political changes that introduce new regulations or restrict certain business activities. This type of
risk emphasizes the importance of a company’s ability to adapt and respond to external challenges,
as well as the need for contingency plans and business continuity strategies
[17]
.
Market risk
Market risk refers to the potential risk that emerges from the volatile nature of market
prices. This risk can be further categorized into two types: systematic risk and unsystematic risk.
Systematic risk is characterized by its influence on the overall market, impacting numerous
investments simultaneously. On the other hand, unsystematic risk solely impacts individual
securities or specific sectors, thus being more localized in nature
[18]
.
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Legal risk
Legal risk stems from modifications in laws and regulations which can have an impact on
the worth of an investment. This form of risk can be divided into two classifications: legislative
and litigation risks. Legislative risks arise due to alterations in laws and regulations that directly
influence the value of an investment, whereas litigation risks emerge from legal actions directed
towards either a company or an individual
[19][20]
.
USING FINANCIAL DERIVATIVES TO HEDGE FINANCIAL RISKS
Financial derivatives have been widely recognized as highly effective tools for managing
and mitigating financial risks. Their usage dates back to the 18
th
century when they were first
employed in commodity futures markets in Japan and Chicago. Initially, derivatives were utilized
to hedge against price fluctuations in goods by exchanging one position for another. Over time,
derivatives evolved to safeguard against the depreciation of foreign currencies. This was
particularly important for wholesale exporters who faced significant currency risks and needed to
ensure the value of their collections at the time of the foreign trade agreement. To protect
themselves from exposure to currency risks, they turned to financial derivatives
[21]
.
While derivatives can involve high risks, they are not inherently riskier than spot
transactions. From a microeconomic standpoint, derivatives carry similar market risks as the
underlying spot transactions they are based on. In terms of risk, derivatives do not introduce any
novel risks that do not already exist in cash markets.
The differences in risk only emerge when directly comparing futures transactions to the
underlying assets. Pricing derivatives often lack transparency, especially for private investors, as
their value is not solely determined by supply and demand, unlike cash market securities. In
addition to the price of the underlying asset, other factors such as remaining maturity can play a
crucial role in determining the price of derivatives. This complexity can pose challenges for private
investors to comprehend. Furthermore, depending on the financial agreement’s structure, there
may be a risk of requiring additional funds on the maturity date, contrary to the original intention.
Moreover, derivative prices are susceptible to the same stochastic uncertainty as the
underlying assets, introducing market risk. However, due to the leverage effect, derivatives can
amplify losses, including the possibility of total loss, during negative price movements.
The risk management process proceeds through the following stages
[21]
:
a)
Communication and consultation
– carried out with stakeholders at all levels of the risk
management process, while considering the process itself.
b)
Determining the context
– involves establishing the external, internal, and risk
management framework within which the subsequent stages will operate.
c)
Identifying risks
– determining when, where, why and how events can be prevented,
mitigated, delayed or amplified in order to achieve objectives.
d)
Risk analysis
– identifying and evaluating existing controls, as well as assessing the
potential consequences and likelihood of risks.
e)
Risk assessment
– comparing the estimated level of risk with pre-determined criteria,
and weighing the trade-off between potential benefits and unfavorable outcomes. This aids in
making decisions regarding the scope and nature of risk treatment.
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f)
Risk management
– entails the development and implementation of specific, cost-
effective strategies and plans to maximize potential benefits while minimizing potential costs.
g)
Monitoring and review reporting
– it is essential to actively monitor the effectiveness of
each stage of the risk management process to ensure ongoing progress.
Historically, managing balance sheet risk involved protecting the bank from various risks.
However, contemporary practices increasingly rely on off-balance sheet derivative financial
instruments such as forwards, futures, options and swaps. With the growing utilization of these
derivatives, financial institutions generate higher fees and revenues.
Financial institutions and companies engage in derivative transactions primarily to
safeguard themselves from various forms of financial risk associated with their operations. The
motivations of market participants entering derivatives transactions vary depending on their
perspective. Banks aim to manage market and credit risks for export companies with high currency
volatility. They may also engage in market speculation or arbitrage.
On the other hand, companies typically utilize derivatives to mitigate currency and interest
rate risks. For example, they may enter into contracts with banks to buy foreign currency in the
future or adjust interest rates. If commodities are traded on an exchange, futures contracts can be
utilized. Currency options may be purchased if there is an expectation of domestic currency
depreciation.
Overall, derivatives provide a more flexible, efficient, and accurate approach to managing
risks, reducing market uncertainty, and limiting risks for individual participants and the overall
financial and economic system.
CONCLUSION
Risk management is an essential aspect of effective management and is also a legal
requirement. As organizations strive to enhance their material, energy and economic capabilities,
there is a noticeable trend towards increased risks. This, in turn, leads to more significant and
severe consequences when a risky event occurs. It is important to note that the impact of these
hazards is not limited to the system environment but often extends to a broader territory, posing a
threat to individuals, resources and the environment.
To address this, proactive measures must be taken to eliminate or minimize the causes and
effects of risky events, as well as to mitigate losses and address consequences when such events
do occur. This forms the foundation of risk management. Risk itself represents uncertainty and the
possibility of loss due to unfavorable changes in risk factors. These risk factors encompass all the
causes that influence risk but cannot be controlled by organizations directly.
In today’s dynamic business environment, organizations face constant changes. They must
be capable of quickly adapting to these changes and addressing them effectively. Risk management
serves as a valuable tool in anticipating and responding to these changing circumstances. It enables
managers to forecast unfavorable events or circumstances that can be averted, align organizational
goals, and allocate control procedures and resources to primary activities and associated risks.
The futures contract, developed by financial engineers, is one of the prominent derivative
instruments used to mitigate increasing risks related to price and interest rate fluctuations. Futures
contracts are derived from specific assets, such as commodities, securities, currencies or stock
indexes. Initially, they were intended as purchase agreements with a forward clause, which allowed
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for delayed delivery and payment. However, over time, futures and other derivatives have gained
an independent market existence separate from the underlying assets. The derivative’s value at
maturity is now influenced indirectly by the underlying asset, rather than being directly tied to it.
Additionally, the impact of the stock market on the derivative’s value is not realized until the price
difference is determined.
Derivatives offer a significant advantage in terms of risk management since they facilitate
the transfer of market and price risks from the underlying asset to the financial derivative through
contractual arrangements. Nevertheless, there are also drawbacks associated with derivative
financial instruments, including the potential for total loss.
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