Risk Mitigation

Financial Derivatives and Beta

Certain alternative investments, such as futures and forward contracts, swaps, and options, can be used to lower risk while increasing return.

Certain alternative investments can be used to lower risk while increasing return. Futures contracts and forward contracts are valuable to firms because they improve financial stability. The firm has the assurance that the commodities, basic goods such as raw materials and agricultural products, are delivered at a prearranged price, protecting the firm from unforeseen price changes. Futures contracts and forward contracts derivatives benefit these firms by making future cash flow, the total volume of money that moves into and out of a company for a given future period, predictable. This cash flow stability allows firms to increase the amount of liquid capital, assets that are easily converted to cash, and make more accurate projections on earnings. Investors value stability and favor a strategy that reduces volatility, providing additional shareholder value. This creates the potential to increase the value of the firm's stock.

Swaps are a valuable hedging strategy for businesses and financial institutions that wish to take an active role in their debt management. Swapping allows businesses to choose the type of interest rates that best suit current needs. Banks commonly use swap derivatives with hedging strategies. For example, the hypothetical First Federal World Bank has debt financed at a variable rate. This same bank provides loans to customers at a fixed rate. If the loan rate on the bank's debt increases substantially, it could put the bank in jeopardy. The bank may hedge this risk by entering into a swap contract with another firm. The positive cash flow from the fixed-rate loan may be swapped for the greater cash flow of a floating rate. This swap will keep the bank's positive cash flow greater than its obligated debt payment.

Along with manageable amounts of risk, options are attractive to speculators for their gain potential. Consider a speculator that has researched shares in Cogs Inc., a hypothetical cog-and-parts manufacturing company. The speculator concluded that the stock is undervalued and is confident that the stock value will increase significantly by a specific date. An options contract allows this speculator to pay a premium for a call option at an agreed-upon strike price. If the stock price behaves as the speculator anticipated, the share will be purchased at the strike price, and the speculator will realize gains. If the stock does not perform as expected, the speculator has the option to decline purchase and has only to forfeit the premium. Options contracts allow speculators to invest without fully exposing themselves to the market by actually purchasing stock.

Call option investments and put option investments are optional agreements to buy or sell an underlying asset at a given strike price. For example, with call options, the strike price of the underlying asset is less than the price at the agreement's expiration. However, this is dependent upon market conditions and if the strike price is less than the actual price then a gain can be achieved or a loss avoided. Using a bank note to settle the call option, the bank note does not grow for the duration of the call option. Thus, the call option investment is the sum of the call option and the bank note from agreement to expiration. During a put option agreement, the seller has the right to sell the underlying asset if that asset depreciates relative to the strike price. Conversely, a put option loses its value as the underlying stock increases. It also decreases in value as the expiration date approaches. When the selling price of the underlying asset exceeds the strike price, the owner will exercise the option not to sell. Thus, the put option investment is the sum of the put option and the underlying asset.

Call and Put Options

Investors prefer call and put options to reduce their total market exposure in an attempt to decrease any losses. A put option is a contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price and within a specified time frame. A call option is an agreement that allows the buyer to purchase an underlying asset at the strike price before contract expiration.