Derivatives As A Risk Transfer Technique

Published Date: 02 Nov 2017

Pritpaul Walia

Walter Chao

FI 483 Risk Management & Insurance

4 February 2014

Derivatives as a Risk Transfer Technique

Risk has many definitions depending on the industry and profession in question. IT Consultants, Economists, Scientists, Doctors and Finance professional each have their own concept of what risk is to them. An underlying similarity that all professionals have regarding the meaning of risk is the concept of uncertainty. For example, a Doctor will view the risk of developing cancer as being present because of uncertainty being present in the long term health of an individual. Although a Doctor will recommend eating healthier and exercising as risk mitigation, yet there is no way of being completely certain that an individual will not develop cancer at some point in their life. Finance professionals view risk in financial terms such as the risk that an investor could incur a financial loss. Although financial professionals use risk mitigation tools such as diversification, hedging or insurance there is still no way of guaranteeing to an investor that they will never experience a loss. With this concept in mind, I will define risk here as the uncertainty relating to the occurrence of a loss.

A Derivative is a financial instrument whose price depends on, or is derived from, the price of another asset. There are many types of derivatives but I will be focusing on options contracts, forwards, futures and weather derivatives as a way to transfer investment risk away from the investor in order the minimize the impact of a financial loss much in the same way insurance is used to mitigate risk.

Options contracts fall into two basic categories: calls or puts. In a call option contract the contract buyer has the right but not the obligation to purchase a fixed quantity from the seller (writer) at a fixed price before a certain date. A put option contract gives the contract buyer the option to sell a fixed quantity to the seller (writer) at a fixed price before a certain date. Every option contract has both a buyer and a seller otherwise known as the writer. The contract buyer has the right but not the obligation to initiate the exchange and the seller is obligated to perform if the buyer chooses to exercise their contract rights.

The factors affecting options prices are as follows:

The current stock price = S

The strike (exercise) price = K

The time to expiration = T

The volatility of the stock price = σ

The risk-free interest rate, r

The dividends expected during the life of the option

The fixed price in an option contract is the exercise or strike price. The strike price is the price at which the contract buyer either purchases from the contract seller (call option) or sells to the contract seller (put option). The time to expiration, maturity date or contract expiration date is the date at which your contract expires and can no longer be exercised. When purchasing the option contract from the seller the option buyer makes a nonrefundable payment to the option seller, called the option premium, to obtain the rights of the option contract.

Options contracts can be used as a risk transfer tool by implementing several different kinds of options strategies when you have investments in financial equities such as stocks. One option strategy involves buying a put option on a stock and buying the stock itself. This strategy is known as the "protective put strategy". The choice of strike prices determines when the downside protection comes into effect. If the stock continues to increase in value, the investor is still benefiting from gains. If the stock falls below the strike, as originally feared, then the investor has the option of exercising their contract. If exercised, the put contract triggers the sale of the stock. The strike price sets the minimum exit price. If the long-term outlook has turned bearish, this could be the most sensible move. As in insurance this kind of strategy is to protect form a financial loss. If the underlying stock continues to increase in value then the investor would not exercise their contract and the put option would expire after the expiration date. As in insurance options have a premium and if not used the premium is gone but you have the benefit of knowing that there is no loss and if there was you could have exercised the put option.

Here is an illustration of how the "protective put strategy" works:

Another strategy using stock equities would be "writing a covered call". In this type of strategy your portfolio would consist of a long position in a stock plus a short position in a call option. The long position "covers" or protects the option seller from the payoff on the short call that becomes necessary if there is a sharp rise in the stock price. This is a hedging strategy when you are the seller or writer of the call option. Normally, you’ll sell one contract for every 100 shares of stock. In return for selling the call options, you collect the option premium. But that premium comes with an obligation. If the call option you sold is exercised by the buyer, you may be obligated to deliver your shares of the underlying stock. This option strategy is a type of risk transfer for the seller of an option contract.

A forward contract is similar to a futures contract in that it is an agreement to buy or sell an asset at a certain time in the future for a certain price. The difference is that futures contracts are traded on exchanges and forward contracts trade in the over-the-counter market. In a forward contract one party agrees to purchase the underlying instrument in the future from a second party at a price negotiated and set today. Forward contracts are financially settled once at the maturity date at the forward price agreed on the day the contract is entered into. In a forward contract one party assumes a long position and agrees to buy the asset at a future date and the other party assumes a short position and agrees to sell the asset today at the today’s price.

One of the ways in which a forward contract can be used as a type of risk transfer can be seen through companies that have international operations or domestic companies that have international suppliers. For example, say it is April 18, 2013 and a US company must pay €10 million on August 01, 2013 for goods purchased in Germany. A US company can purchase a 3-month forward contract to lock in today’s exchange rate in case the currency exchange rates become unfavorable by August 01, 2013. This type of transaction will provide stability in the company’s future cash flows and eliminate the uncertainty that comes along with currency rate risk.

Future contracts permit the frequent transfer of ownership and delivery obligations until a future date. Once created a futures contract can be settled in two ways: delivery of the underlying asset at contract maturity or more commonly the liquidation of a prior position by an offsetting transaction. Futures are available through a centralized marketplace that allows investors to trade contracts with each other and through regulated trade practices. As a general practice money deposits are made by both the futures buyers and sellers to ensure the payments of future obligations. Futures contracts are traded through exchanges such as the Chicago Mercantile Exchange (CME). The CME is the world’s largest exchange for derivative products.

Companies can use futures as a risk transfer tool by purchasing or selling futures on the types of assets that are used as production inputs. For example a soybean farmer can hedge against lower future prices by selling futures on the market now at current rates if the farmer feels that future prices will be unfavorable. A farmer can base his decision on future supply of soybeans taking into consideration weather patterns and global supplies of soybeans.

Another futures strategy is a long hedge. This strategy is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now. An example is where a copper products manufacturer knows it will need 50,000 pounds of copper on July 15. The futures price for July delivery is 320 cents per pound. The manufacturer can hedge its position by taking a long position in 2 futures contracts on the COMEX division of NYMEX and close its position on July 15. Each contract is for 25,000 pounds of copper. This strategy has the effect of locking in the price of the required qty of copper at a price of 320 cents per pound. If the price on July 15 ends up being 325 cents per pound then the manufacturer will have a gain of $2,500 on the futures contracts.

Exchange traded Weather Derivatives have been a great tool for certain companies to mitigate risk related to adverse weather conditions. It is estimated that 20% of the economy is directly affected by the weather such as agriculture, energy, entertainment, travel, construction and others. For these types of companies it makes sense to consider hedging their weather risk in much the same way as a company would hedge for currency risk or interest rate risk. Insurance companies have usually provided for protection in case of adverse weather but that type of protection is limited to a company’s buildings or property. Weather derivatives protect against loss of business due to adverse weather. An example would be a sprinkler company whose sales fluctuate due to the weather. When it’s sunny and dry, sales go up; when its rainy and wet, sales go down. For a ski resort, there sales depend entirely on the amount of snowfall each year. A year with excessively low amounts of snowfall could rend a ski resort bankrupt so it makes send for them to protect themselves financially through weather derivatives.

Risk management is the science of identifying uncertainty and providing solutions. Insurance is a product that assists in mitigating many kinds of risks and there are many types of products available in the market that work just like insurance but are referred to by other names. In the Financial industry there are many tools available to mitigate risk and derivatives are an excellent way of transferring that financial risk to another party.