Use of Derivatives in Risk Management
A derivative is described as a price that is formulated based on the value of underlying assets (Blackwell, Griffiths, & Winters, 2007). It is described as a security against the fluctuations in the economy. Blackwell et al., (2007) describe it as a form of contract established between the two parties based on the value of the underlying assets. The fluctuations in the value of currencies, interest rates, bonds, and stocks determine the derivative value (Blackwell et al., 2007). Moreover, derivatives play a great role in cases of fluctuations or adverse events. Therefore, they have a significant impact, both negative and positive, on any economy.
Blackwell et al., (2007) explain that derivatives are factors that minimize economic crisis by reducing uncertainty through management of undesirable economic changes. As such, they can be used to avoid the negative implications that accompany changes brought by economic fluctuations such as shifting oil prices (Blackwell et al., 2007). Such a move helps to avoid the economic crises that may arise in case there is a shortage of such products. According to Chance and Brooks (2015) “For any stored asset, the spot price is related to the expected future spot price…this relationship is used to explain future pricing” (p. 289). Therefore, derivatives are crucial in stabilizing the economy in cases where the future profits and prices are unpredictable. In essence, derivatives are vital in the economy for mitigating many risks that would give rise into big economic crises.
In fact, the extent to which derivatives can fuel the current economic woes can be estimated by the danger expressed in the less transparency of accounting statement and the reliability revealed. Managing the derivatives might at times be sophisticated, hence accounting for some of them may be conducted, which implicates an adverse effect on the economy. In some cases, the involved traders may consent on the price of the traded derivatives, but their agreement may vary in case of illiquid securities. As such, the derivatives are priced differently by numerous enterprises which lead to the fluctuations experienced in the current situation. Indeed, derivatives can be seen to be a contributing factor to the economic crisis.
References
Blackwell, D. W., Griffiths, M. D. & Winters, D. B. (2007). Modern financial markets: Prices, yields, and risk analysis (1st Ed.). New York: Wiley.
Chance, D. M., & Brooks, R. (2015). Introduction to derivatives and risk management. Boston: Cengage Learning.
