Derivatives are becoming increasingly important in world markets as a tool for risk management. Derivatives instruments can be used to minimise risk. Derivatives are used to separate the risks and transfer them to parties willing to bear these risks. The kind of hedging that can be obtained by using derivatives in cheaper and more convenient than what could be obtained by using cash instruments. It is so because, when we use derivatives for hedging, actual delivery of the underlying asset is not at all essential for settlement purposes. The profit or loss on derivatives deal alone is adjusted in the derivative market.
Moreover, derivatives do not create any new risk. They simply manipulate risks and transfer them to those who are willing to bear these risks. To cite a common example, let us assume that Mr. X owns a car. If he does not take an insurance, he runs a big risk. Suppose he buys an insurance, (a derivative instrument on the car) he reduces his risk. Thus, having an insurance policy reduces the risk of owing a car. Similarly, hedging through derivatives reduces the risk of owning a specified asset which may be a share, currency etc.
Hedging risk through derivatives is not similar to speculation. The gain or loss on a derivative deal is likely to be offset by an equivalent loss or gain in the values of underlying assets. ‘Offsetting of risk’ in an important property of hedging transactions. But, in speculation one deliberately takes up a risk openly. When companies know well that they have to face risk in possessing assets, it is better to transfer these risks to those who are ready to bear them. So, they have to necessarily go for derivative instruments.
All derivative instruments are very simple to operate. Treasury managers and portfolio managers can hedge all risks without going through the tedious process of hedging each day and amount/share separately.
Till recently, it may not have been possible for companies to hedge their long term risk, say 10-15 year risk. But with the rapid development of the derivative markets, now, it is possible to cover such risks through derivative instruments like swap. Thus, the availability of advanced derivatives market enables companies to concentrate on those management decisions other than funding decisions.
Further, all derivative products are low cost products. Companies can hedge a substantial portion of their balance sheet exposure, with a low margin requirement.
Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it is also possible for companies to get out of position in case that market reacts otherwise. This also does not involve much cost.
Thus, derivatives are not only desirable but also necessary to hedge the complex exposures and volatilities that the companies generally face in the financial markets today.