The Risks Associated With Derivatives Instruments - Essay Sample

Introduction

Derivative instruments are contracts that generally allows an investor, a business or a municipality to transfer rewards and risks that are associated with the financial or commercial outcomes to other existing parties. Proper holding of a derivative instrument can, therefore, the existing risk of bad harvest, negative events and also adverse market fluctuation. The four major types of risks that are associated with the derivative instrument includes

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Commodity Risk

A business or an organization that has to buy a given good or commodity in future is exposed to a risk whereby there might a rapid increase in the price of that particular commodity. This kind of risk can be managed by the business if the future price of that particular commodity is agreed on today. This, therefore, indicates that the seller of that contract is obliged to deliver the same type and quantity of the commodity in the future using the present price that has been agreed upon. The commodity futures contract is referred to as regulated exchange and thus the risk can be managed if a proper agreement is reached in the present.

Stock Market Risk

The stock equity option is also another common derivative and can be used to decrease or increase the exposure to the increased risk of continuously fluctuating market prices. This can be controlled by ensuring that there is a common laid down strategies for market price fluctuations.

Interest Rate Risk

Most of the companies and business organizations issues bonds to various investors that pay either floating or fixed rates of interest. In a situation that a company gives out a fixed rate debt then the risk that comes out here is that the interest rate may fall and the company will still be stuck paying the initial rate upon which the agreement was done. This particular kind of risk that can highly affect the company organization can be offset or managed by a derivative which is known as the interest rate swap. Swaps are a general organizational agreement to exchange the multiple payment systems over an extended period of time.

Credit Risk

The credit risks are generally the market perception of the organization probability of default. Investors are in this case expose to credit in case they own the organization debt. This kind of risk can be managed using credit default swap that really offers protection against the cooperate default by giving the investors an opportunity to take a position on the default risk of that particular to cooperate bond issuer.