Use of Derivatives in Risk Management in Treasury

What are Derivatives?

Derivatives are financial instruments that derive their value from an underlying asset, such as a stock, bond, or commodity. Derivatives can be used to hedge risk, speculate on the future price of an asset, or simply to generate income.

How are Derivatives Used in Risk Management?

Derivatives can be used to hedge risk in a number of ways. For example, a company that imports goods from another country could use a currency derivative to hedge against the risk of changes in the exchange rate. This would protect the company from losses if the value of the currency it imports in falls.

Derivatives can also be used to speculate on the future price of an asset. For example, a trader might buy a futures contract on oil if they believe that the price of oil is going to rise in the future. If the price of oil does rise, the trader will make a profit on their investment.

Finally, derivatives can be used to generate income. For example, a company might sell a call option on a stock if they believe that the price of the stock is not going to rise very much in the future. If the price of the stock does not rise, the company will keep the premium they received for selling the option.

MCQs on the Use of Derivatives in Risk Management in Treasury:

1. Which of the following is not a derivative?
   • Futures contract
   • Option
   • Swap
   • Currency swap
   • All of the above are derivatives
   • Answer: All of the above are derivatives
2. Derivatives can be used to hedge risk, speculate on the future price of an asset, or simply to generate income.
   • True
   • False
   • Answer: True
3. A company that imports goods from another country could use a currency derivative to hedge against the risk of changes in the exchange rate.
   • True
   • False
   • Answer: True
4. Derivatives can also be used to speculate on the future price of an asset.
   • True
   • False
   • Answer: True
5. Finally, derivatives can be used to generate income.
   • True
   • False
   • Answer: True

Conclusion

Derivatives are a powerful tool that can be used to manage risk in a number of ways. However, they are also complex instruments and should only be used by experienced treasury professionals.

Here are some additional points to keep in mind about the use of derivatives in risk management:

• Derivatives should be used as part of an overall risk management strategy. They should not be used as a substitute for sound risk management practices.
• Derivatives can be risky instruments and can lead to losses if they are not used properly.
• Derivatives should be used in accordance with the company’s risk appetite and financial objectives.
• Derivatives should be regularly monitored and reviewed to ensure that they are still effective in managing risk.

It is important to remember that derivatives are not a guarantee against loss. They simply provide a way to manage risk.