Use of derivatives in Asset-Liability Management (ALM)

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 against risk, speculate on future price movements, or generate income.

How are Derivatives Used in ALM?

Derivatives can be used in ALM to manage a variety of risks, including:

  • Interest rate risk: Derivatives can be used to hedge against interest rate risk by locking in a fixed interest rate for a future period. For example, a company that has a floating interest rate loan can enter into an interest rate swap to exchange its floating interest rate for a fixed interest rate.
  • Currency risk: Derivatives can be used to hedge against currency risk by locking in a future exchange rate. For example, a company that imports goods from a foreign country can enter into a currency swap to exchange its home currency for the foreign currency at a predetermined exchange rate.
  • Commodity risk: Derivatives can be used to hedge against commodity risk by locking in a future price for a commodity. For example, a company that uses oil in its production process can enter into a futures contract to purchase oil at a predetermined price in the future.

MCQs on Use of Derivatives in Asset-Liability Management (ALM):

  1. Which of the following is not a derivative?
    • Forward contract
    • Futures contract
    • Swap
    • Option
    • All of the above are derivatives
    • Answer: All of the above are derivatives
  2. Derivatives can be used to hedge against interest rate risk.
    • True
    • False
    • Answer: True
  3. Derivatives can be used to hedge against currency risk.
    • True
    • False
    • Answer: True
  4. Derivatives can be used to hedge against commodity risk.
    • True
    • False
    • Answer: True
  5. Derivatives are always a good way to manage risk.
    • True
    • False
    • Answer: False

Conclusion

Derivatives can be a valuable tool for ALM managers, but they should be used with caution. Derivatives can be complex and risky, and they should only be used by experienced investors who understand the risks involved.

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

  • Derivatives should only be used to manage specific risks that are relevant to the company’s business.
  • Derivatives should not be used to speculate on future price movements.
  • Derivatives should be used in a way that is consistent with the company’s risk appetite and financial objectives.
  • Derivatives should be used with the advice of a financial advisor who understands the company’s specific needs.