Essay Example on Risk Management in Global Business: Navigating Uncertainty

Risk management is vital in the current environment of business uncertainties. The trading of commodities and products has been determined over time by forces of demand and supply (Ahmadi and Ariankia, 2017, pg. 25). Due to liberalization and globalization all over the world, the conducting of international trade and business has increased at a high rate. International trade interaction had brought about periodic trends of financial asset prices, making them hard to predict (Zhao et al., 2013 pg.20). Exchanges rates and interest rates have also been affected, making the business word exposed to financial risk, which grows each day. The essays are, therefore, explaining the role of future and forward contracts as tools for market risk management.

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In the provision of effective and less costly solutions for the risk of unpredictable prices of assets, financial engineering has caused the emergence of some derivatives markets (Chen et al., 2014 pg. 39). The derivatives have acted as a solution for the trading risk attached to the varying prices of financial assets. They are financial instruments connected to a commodity or indicator to enable trading of specific financial risks through them using their rights (Ahmadi and Ariankia, 2017 pg. 26). There are many different derivatives used; however, the two major derivatives are futures and forward contracts. The two derivatives can manage the risk of price changes in stocks, bonds, goods, different currencies, bank interest rates, market indices, among others.

The derivative is a security with a price depending or being derived from a single asset or many (Chen et al., 2014 pg. 40). The process if deriving involves a contract of two or more parties. Fluctuations of the discussed asset determine the values. Underlying assets that frustrate mostly involve stocks, currencies, bank rates, market indexes, and commodities. They are all highly leveraged and volatile. Apart from future and forward contracts, swaps are also commonly used derivatives. The underlying asset is always the determinant of the derivative contract value, which good be to produce the farm, mineral, currencies, both medium and long term bonds and share or warrants available in known stock exchange markets.

Derivatives deliver several benefits that are facilitating the transfer of risks from one party to another, helps to determine future and current prices and smoothen entrepreneurial activities. Savings and investment in the long run increase due to derivatives. Since the people with adverse risk are many, the volumes traded in markets increases significantly (Zhao et al., 2013 pg.21). Derivatives functions in both developing and developed countries and have a contribution to the growth of the capital market.

Forward contracts are agreement involving two parties to purchase or sell a specified quantity and quality of an asset at a pre-determined future time and also pre-determined value. In most cases, forward contracts are of more than 30 days contracts (Redl and Bunn, 2013, pg. 10). Forwards derivatives began in the sixteenth century in the agricultural sector to prevent the risk of adverse price movements. The risk is reduced by the fact that the buyer and the seller will transact business at a specified price in the contract. Despite the different prices of the underlying asset in the spot market at maturity, the price of the transaction remains the contract price (Ahmadi and Ariankia, 2017 pg. 37). The seller and buyer negotiate the term of the contract and agrees on specific conditions. Thus forward contract is legal agreements designed concerning partners' needs with obligations to deliver the underlying asset at the specified terms.

Forward contracts play different roles in an attempt to control or minimize the risks of trading among different players. The first role is risk managing to protect the traders through the alleviation of financial risk. No initial investments are given in forward markets as the contract will be effective in the future. Cash is given to the other party only after the maturity of the contract to settle the contract fully. Only cash hand transfers at maturity of contract enable cash to be less volatile and easily manageable.

Forward contracts enable easy settlement of the underlying asset or subject matter. It enables flexibility as the contract can be settled through several means. Forward contracts can be settled before delivery by cash, and both parties never lose (Zhao et al., 2013, pg.29). In some conditions, traders can transfer the obligation to another party who is willing to take the position. The settlement is flexible, and both parties are secured from the market risk.

Risks involve the trust of the other partner. Forward contracts enable the creation of trade connections and improve trustworthily. The negotiations conducted to formulate the terms of the contract, which builds trust among the traders and links between them are made stronger. Forward contracts reduced the cost of doing business, and its volatility and profits increase. Forward contracts in goods that are not stored benefit both producer and the seller.

Like forward contracts, futures contracts involves an agreement between two parties of buying and selling and buying an asset at a specific price at a pre-decided future date (AlQussi, 2014 pg. 32). Although future contracts share the same characteristics of locking prices as a forward contract, the future is more sophisticated. The theories of financial futures are traced back in the seventeenth century, where it was traded on shares of the Dutch and Indian companies. However modern future has its origin in Japan for rice farmers in Osaka around 18 century. It was supported by the grading system, which ensured the quality agreed on the contract was kept until the settlement of the contract. The grading system led to the standardization of future contracts in currency trading.

Standardization of future contracts is I respect of quality, quantity, date of delivery, and also location. Futures are traded on organized and regulated exchanges, which are setters of quantity and quality of the asset in the contract (Chen et al., 2014 pg. 50). Besides, the exchange platforms decide on the terms and conditions of future contracts. Terms already set are not negotiated among the traders. All participants in the exchanges are equally treated, including the small traders.

Since the future contracts are traded in exchanges, there is always clearinghouse for clearing and offering settling facilities to guarantee the transactions. Only members are supposed to conduct business on the exchanges. Hence a non-member wishing to use futures has to deal with a broker. The brokers are members too and help non-members in matching sellers with buyer's orders without them meeting face to face (Zhao et al., 2013 pg.36). The trading platforms connect sellers and buyers across the world, communicates to parties, and ensure the terms and conditions set are followed.

Users of futures need to deposit the value of the contract with the exchanges before trading. The minimum amount to be kept in the account is always stated. The settlement of contracts is on daily bases, which has an impact on the contract price (Zhao et al., 2013 pg.37). Increment of the contract price results to profit for the holder who can withdraw it, and the decrease in prices is a loss to the holder. The contracts protect the value of commodities and somehow finances the storage expenses as the future cost is affected by carrying costs.

Future contracts, therefore, counteracts default risk, and the traders are protected by set regulations (Ahmadi and Ariankia, 2017 pg. 41). The supreme aim is managing the risk and offering a settlement guarantee. The exchange has the authority to give orders and expel any members who do not abide by the set rules. The market is set to be transparent, the pricing of inventory is fair, and manipulations of the market is hard. The electronic system of trading collects all forces that affect the price of a commodity, and then the price is discovered while maintaining efficiency and low costs. Exchange is highly competitive as the technology used makes the market to quickly react (Zhao et al., 2013 pg.39). Prices and transactions are constantly monitored with information continuously captured and reflecting on the intrinsic value of the commodity.

Conclusion

In conclusion, forward and futures contracts have all earned significance in equal measure among financial products. They are easy to trade and provides the opportunity of transferring risk. By use of the two contracts, anyone can hedge risks like commodity risk, currency risk, and interest rate risk. The derivatives minimize the risks of traders and ensure control when trading in the markets of uncertainties.

References

Ahmadi, R., and Ariankia, N., 2017. American Option Pricing of Future Contracts to Investigate Trading Strategies; Evidence from North Sea Oil Exchange. Advances in Mathematical Finance and Applications, 2(3), pp.67-77. http://amfa.iau-arak.ac.ir/article_533102.html

AlQussi, H., 2014. The Regulation of forwarding Dealing and Future Sales In the Kuwaiti Securities Exchange (Between Allowing Future Contracts and Protection the Direct Market). Journal of Law/Magallat al-Huquq, 38(2). https://web.a.ebscohost.com/abstract?

Chen, X., He, Y., Song, Y.H., Nakanishi, Y., Nakanishi, C., Takahashi, S. and Sekine, Y., 2004. Study of impacts of physical contracts and financial contracts on bidding strategies of GENCOs. International Journal of Electrical Power & Energy Systems, 26(9), pp.715-723. https://www.sciencedirect.com/science/article/abs/pii/S0142061504000742

Redl, C., and Bunn, D.W., 2013. Determinants of the premium in forward contracts. Journal of Regulatory Economics, 43(1), pp.90-111. https://link.springer.com/article/10.1007/s11149-012-9202-7

Zhao, Y., Qin, J., Rajagopal, R., Goldsmith, A. and Poor, H.V., 2013, October. Risky power forward contracts for wind aggregation. In 2013 51st Annual Allerton Conference on Communication, Control, and Computing (Allerton) (pp. 54-61). IEEE. https://ieeexplore.ieee.org/abstract/document/6736505/