...Use of Derivatives in Risk Management Teresa Fritz Ashford University Managerial Financial BUS 650 Dr. Wendy Achilles April 2, 2012 Use of Derivatives in Risk Management Risk management is in a company’s wonders all the time, the managers need to watch closely at all times to stay on top to make sure they have time to react to a risk that may arise. By using derivatives management may be putting their company at risk and need to know the common risks that are involved and know how to avoid them. Ten of the failures are poor governance and tone at the top, reckless risk taking, inability to implement enterprise risk management, nonexistence, ineffective or inefficient risk assessment, falling prey to Herd Mentality, misunderstanding the mindset of “if you can’t measure it, you can’t manage it”, accepting a lack of transparency in high-risk areas, nit integrating risk management with strategy-setting and performance management, ignoring the dysfunctionalities and blind spots of the organizations culture, and not involving the board in a timely manner (Beaumier, DeLoach). The derivatives that are used for risk management are interest rate derivatives such as interest rate swaps, interest rate caps, basic swaps, and rate lock (Kelly). All companies should have a policy that states derivatives can only be used for risk management purposes and not for speculating interest rate movements (Kelly). Derivatives used for risk management can be a good thing and can also be a risky...
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...Case Study on PepsiCo’s Use of Financial Derivatives 1. Introduction 1.1 PepsiCo’s History The Pepsi-Cola Company was incorporated in 1919 by Caleb Bradham, the inventor of the Pepsi-Cola soft drink. PepsiCo became a multinational beverage and snack food company in 1965 when Pepsi-Cola merged with Frito-Lay. Since the 1965 merger PepsiCo has expanded its operations by acquiring Quaker-Oats, Tropicana, and Gatorade brands. With sales of $66.86 billion in 2014 and with products sold in over 200 countries, PepsiCo is one of the leading food and beverage companies in the world (PepsiCo, 2014). 1.2 PepsiCo’s Industry The beverage and snack food industries are both in the mature stage in their life cycles, and companies in these industries largely depend on product innovation, brand recognition, and low prices to remain competitive. Like all companies PepsiCo faces risk of increases in operating expenses and decreases in net income due to market risk. Companies in PepsiCo’s industry have been forced to expand its product offerings into healthy foods and drinks due to an insurgent health and wellness in American culture. 1.3 PepsiCo’s Competitors PepsiCo’s top competitors consist of The Coca-Cola Company, Dr Pepper Snapple Group, and Nestle; additionally, because PepsiCo is a multinational company it must also compete with countless local snack and beverage companies across the globe. Coca-Cola has been viewed as PepsiCo’s main rival for around 100 years, and the competition...
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...industry-wide, cross-sectional study concentrates on recent foreign exchange risk management practices and derivatives product usage by large non-banking Indian-based firms. The study is exploratory in nature and aims at an understanding the risk appetite and FERM (Foreign Exchange Risk Management) practices of Indian corporate enterprises. This study focusses on the activity of end-users of financial derivatives and is confined to 501 non-banking corporate enterprises. A combination of simple random and judgement sampling was used for selecting the corporate enterprises and the major statistical tools used were Correlation and Factor analysis. The study finds wide usage of derivative products for risk management and the prime reason of hedging is reduction in volatility of cash flows. VAR (Value-at-Risk) technique was found to be the preferred method of risk evaluation by maximum number of Indian corporate. Further, in terms of the external techniques for risk hedging, the preference is mostly in favour of forward contracts, followed by swaps and cross-currency options This article throws light on various concerns of Indian firms regarding derivative usage and reasons for non-usage, apart form techniques of risk hedging, risk evaluation methods adopted, risk management policy and types of derivatives used. Key Words: Foreign Exchange, Financial Derivatives, Hedging,...
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...INDIAN DERIVATIVES MARKETS 1 Asani Sarkar 1 I gratefully acknowledge the assistance of Arkadev Chatterjea, Neel Krishnan, Golaka C. Nath and V. Soundararajan in the preparation of this article. The views expressed in this article are mine alone, and do not necessarily reflect those of the Federal Reserve Bank of New York, or the Federal Reserve System. Derivatives OUP 1 1. Rise of Derivatives The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. 2 Derivative securities provide them a valuable set of tools for managing this risk. This article describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term. 2. Definition and Uses of Derivatives A derivative security...
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...investments. It is a form of an investment where there is a larger percentage chance of capital loss or a high likelihood of underperformance. The purpose of this paper is to research high-risk investment brokerage firms that have been indicted or convicted of ethical violations to provide insight and understanding of this market segment. To realize this objective, the Internet will be used as the chief research method. The information sources will be derived from academic databases, such as Wiley Online Library and ProQuest. The given paper is divided into six sections. The first section will attempt to explain why investors may be attracted to high-risk investments, such as exchange-traded derivatives, global funds, and other complex investment vehicles. The second section will concern the analysis of the risk associated with exchange-traded derivatives, such as futures and options,...
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...misleading the Office of the Comptroller of Currency of their Synthetic Credit Portfolio. The author’s intention is to inform what went wrong with the trading in the derivatives market by JPMorgan Chase. The key question the author is addressing is why the CIO deviated from their standard midpoint markings to later assigning more favorable prices. Also, the author is addressing why the OCC was unaware of the losses and the risk associated with the SCP. The most important information in this article is the deceptive actions committed by the CIO in the London Whale Trades. It became apparent that senior managers downplayed the problems of the SCP and kept describing the portfolio as a risk-reducing hedge, when in actuality it was a massive portfolio losing billions of dollars and had stopped providing credit loss protection to the bank. The whale trades shows how financial institutions engage in high risk trading activities with federally insure deposits and attempted to divert attention from these synthetic derivatives. The main conclusion s in this article is a combination of poorly executed hedging decisions by the CIO of JPMorgan Chase in their SCP. The CIO failed to alert its regulators of their actions in constructing this portfolio that was filled with complex high risk synthetic credit derivatives. JPMorgan Chase claimed that its SCP functioned as a hedge against bank credit risks, but failed to identify the assets being hedged, test the effectiveness of the hedging...
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...In 2007, the US financial system began to collapse. The trust link between the different financial institutions, such as Investment Banks or Insurance Companies, broke – crashing all the financial system. The collapse of all the US banking system had consequences everywhere in the world. No one, from the strongest European countries to the poorest places in the world, was spared. To understand the whole current situation, we have to look back in the 80s and 90s when the deregulation started. Deregulation means lowering the laws and restrictions voted by the government, which lowers the government control over how business is done, between who and who. It started with the deregulation of how the loans are used. Before the deregulation, the financials institutions could not use the money of the individuals. But they came public, so they had access to a lot of money provided by the stockholders. This situation lead to two crises in the eighties, and in the nineties. Between 2001 and 2007 happened a period, called “bubble”, of high deregulation and speculation. It lead to the financial crisis we are now still facing. The main point of this essay is to understand how the system have collapsed, who and what was involved. It will also try to explain why the US crisis has spread to the other financial markets all around the world. 1/ The play of the interest rate during the US crisis In the early 2000s, the interest rate was kept down by the Federal Reserve (FED) to boost...
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...Journal of Empirical Finance 7 Ž2000. 317–344 www.elsevier.comrlocatereconbase Firms, do you know your currency risk exposure? Survey results Claudio Loderer ) , Karl Pichler a a Institut fur Finanzmanagement, UniÕersitat Bern, Engehaldenstrasse 4, Bern 3012, Switzerland ¨ ¨ Abstract This paper surveys the currency risk management practices of Swiss industrial corporations. We find that industrials are unable to quantify their currency risk exposure and investigate possible reasons. One possibility is that firms do not think that they need to know because they use on-balance-sheet instruments to protect themselves before and after currency rates reach troublesome levels. This is puzzling because performing a rough estimate of at least the exposure of cash flows is not prohibitive and could be valuable. Another puzzling finding is that firms use currency derivatives to hedgerinsure individual short-term transactions, without apparently trying to estimate aggregate transaction exposure. q 2000 Elsevier Science B.V. All rights reserved. JEL classification: G15; G30 Keywords: Currency risk exposure; Swiss industrial corporation; On-balance-sheet instruments 1. Introduction This paper surveys the currency risk management practices of Swiss industrial corporations. Many of them sell most of their output abroad and would therefore seem to be heavily exposed to currency risk. In fact, currency risk can be substantial. Between 1978 and 1996, the Swiss franc experienced dramatic...
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...Financial Institutions Center Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry by J. David Cummins Richard D. Phillips Stephen D. Smith 98-19 THE WHARTON FINANCIAL INSTITUTIONS CENTER The Wharton Financial Institutions Center provides a multi-disciplinary research approach to the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest. Anthony M. Santomero Director The Working Paper Series is made possible by a generous grant from the Alfred P. Sloan Foundation Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry By J. David Cummins Wharton School, University...
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...The article Wielding Derivatives as a Tool for Deceit by Floyd Norris, a writer for the New York Times, talks about how derivatives can be used as “weapons of mass deception”. Enron is a classic example of this. They used phony accounting methods, including derivatives, to make their financial statements seem stronger and less risky than they actually were. The banks, that were essentially giving them loans, were also involved in this scheme. The latest news of large-scale use of derivatives to deceive is the case of Italy and Greece entering into the Euro. The government received money, which was essentially a loan, but was able to keep it off the balance sheet because of its title. This made the financial statements look better so that the country could join the Euro. The article compared this to a student cheating on entrance exams to be accepted into a better college. This article brings into question the moral and ethical decisions businesses must make regarding their financial actions. Just because something is technically legal to do, does not mean it is ethical. Key individuals, who are in charge of what a business does, need to be involved and knowledgeable enough to understand when something like this is happening. If the business is doing something to deceive others, it is probably something they shouldn’t be doing. June 27, 2013 Wielding Derivatives as a Tool for Deceit By FLOYD NORRIS Derivatives are not always “financial weapons of mass destruction,” as...
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...future contracts and forward rate agreement Learning objectives Consider the nature and purpose of derivative products Outline features of a futures transaction Review the types of futures contracts available through a futures exchange Identify why participants use derivative markets and how futures are used to hedge price risk Identify risks associated with using a futures contract hedging strategy Explain and illustrate the use of an FRA for hedging interest rate risk 19.1 Derivative contracts- futures and FRA • Future contracts and forward rate agreement (FRAs) are called derivatives because they derive their price form an underlying physical market product • A futures contract is the right to buy or sell a specific item at a specified future date at a price determined today • The risk management function of a derivative-based strategy is to lock-in price today that will apply at a future date. • Two main types of derivative contracts 1. commodity (e.g. gold, wheat and cattle) 2. Financial (e.g. shares, government securities and money market instruments) Hedging using futures contracts • Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party • The change in the market price of a commodity or security is offset by a profit or loss on the futures contract • Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of changes...
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...Bus 171a chap 1-8 HW Chapter 1 Hw probs 2,3,8,9,15-18 2) what is the difference between the claim of a debtholder of GM and an Equity holder of GM? The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal. The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder. The equity holder has a residual claim to assets and income. He can receive funds only after other claimants are satisfied. Income is in terms of dividends, the amount and timing of which are not certain. 3) What is the basic principle in determining the price of a financial asset? The basic principle is that the price of any financial asset is equal to the present value of its expected cash flow, even if the cash flow is not knows with certainty. The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows. 8) explain the difference between each of the follow a. The money market is a financial market of short-term instruments having a maturity of one year or less. The capital markets contain debt and equity instruments with more than one year to maturity; b. The primary market deals with newly issued financial...
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...Derivatives and Hedging Over recent years, the volatility in the financial markets has increased due to substantial changes domestically and internationally. This has given rise to increased financial price risks faced by both domestic and multi-national companies. Financial Derivatives are widely used by corporations to adjust to exposure to currency risk, interest rate risks, commodity price risks, and security holdings risk. Largely, companies are currently exposed to risks caused by unexpected movements in exchange rates and interest rates. Companies with a growing global presence are especially exposed to a wide range of financial risks, in particular foreign exchange risks and interest rate risk. Although, financial risks are the center of business operations of financial service firms, but they also impact the risk exposure of non-financial corporations. The management and supervision of these risks has become vital for the existence of companies in today’s unpredictable financial markets. The major financial risks that most firms are exposed to are interest rate risk, currency rate risk, commodity price risk, and security holdings risk. Interest rate risk is a very common type of risk, and result from a discrepancy in the sensitivity of a firms assets and liabilities to interest rate movements. On the other hand, currency risk exposure is virtually encountered by all firms, even if their exposure is not from a transaction or a translation risk. Many firms are...
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...FIN30014 Financial Risk Management Topic Outline, Reading and Tutorial Questions Semester 2, 2015 ------------------------------------------------- Topic 1: Introduction to Derivatives and Financial Risk Management ------------------------------------------------- Mechanics of Futures Markets Topic Outline * Financial risk management – an overview * The nature of derivatives and their uses for financial risk management * Futures exchanges and futures contracts * Over-the-counter markets and forward contracts * Uses of derivative contracts markets: Hedging, Speculation and Arbitrage * The mechanics of futures markets * opening and closing futures positions * the operation of margins on futures contracts * the role of the “Clearing House” * Futures contracts compared with forward contracts Essential Reading: Hull (2014) Chs. 1 & 2 Additional Reading: Viney, Ch 18, pp. 604 – 613; Ch 19, pp 636-648 Web Resources (Refer to the “External Links” tab on Blackboard) * Financial Pipeline: Derivatives Self-test Quiz Questions Hull Ch. 1: 1.2, 1.4, 1.7 Hull Ch. 2: 2.3, 2.4 (ignore tax questions), 2.5 Tutorial Questions Hull Ch. 1: 1.10, 1.11, 1.12, 1.18, 1.20, 1.21, 1.33 Hull Ch. 2: 2.10, 2.14, 2.16, 2.18, 2.25, 2.26, 2.28 Additional Questions 1. Suppose that on Jan. 4, 2011, an investor...
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...(a) Introduction Financial derivatives are a financial instrument that value is depend upon or derived from price of underlying items such as commodity, indicator or index. Financial derivatives enable participants involved to trade specific financial risks for example, interest rate risk, foreign exchange risk, equity and commodity price risk and credit risk to other entities who are more willing or better suited to take or manage these risks (International Monetary Fund, n.d.). Even though there are some speculators are aim to earn profit by using the financial derivatives. The main categories of derivatives are forward and futures contracts, options and swaps. They are financial instruments that are mainly used to protect against and manage...
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