Analysis of Derivatives in International Financial Management

This essay provides an overview of derivatives and their role in international financial management, focusing on risk management strategies such as hedging. It discusses the limitations of hedging, explores different types of derivatives including forward contracts, future contracts, and option contracts, and provides real-world examples of their application. The essay also addresses how derivatives can mitigate the failings of IFE (International Fisher Effect) and PPO (Purchasing Power Parity) by enabling global diversification and providing tools for price discovery and speculation. It concludes by emphasizing the vital role of derivatives in managing financial risks in an increasingly complex international market.

International Financial management
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Introduction
A derivative is defined as financial contracts that obtains its value from underlying assets.
The agreement by the buyer is to buy the asset on an agreed date at a specific price.
Derivatives are commonly applied to commodities like oil, gold and gasoline though
currencies like the US dollar are also used (Simkovic, 2009).
Arguments against Financial derivatives
Disadvantages of derivatives are clearly understood when the hedging theory is critically
analyzed. The most common technique by firms to minimize or transfer financial risk is the
hedging contracts. The hedging contacts whenever applied are expected to protect the users
from adverse price fluctuations completely. This nature of conclusion regarding hedging is
not justifiable and may be misleading due to the timeline involved in the hedging process.
Incomplete understanding of the two markets necessary for hedging may result in such
generalizations and prompt investors to enter contacts that may see them suffer the financial
losses instead (Hull, 2006).
To have a clear look if the limitations accompanying hedging it is necessary to have a clear
understanding of what hedging contracts are. The nature of the contract is simply a
coincidence purchase and sale within two markets which are expected to behave in a manner
that losses realized in one market will be compensated on the other. This way the investor
expected loss is estimated at zero (Lejot, 2013). These assumptions of perfect market trends
do not hold occasionally. With this hedging may end up being a source of economic loss.
Due to the technicalities associated with market trend analysis derivatives are not normally
investment option for a normal investor. Attempts by individuals to take advantage of such
options is often followed by huge losses as majority rarely understands the derivatives (Lyon,
1923).
Types of derivatives and their roles
Derivatives exist in several categories. In this section will discuss three types and their roles
in real life situations. That is Futures Contracts, Forward Contracts and Options Contracts.
Forward Contracts
Out of the derivatives available presently forward contracts are the simplest and the oldest
form of derivatives. A forward contract is simply an agreement to sell a property at a date in

future. The price of the item is set at the present date. Forward contracts do take place
between the buyer and the seller hence the exchange plays no intermediate role. This reason
means the derivative is more prone to counterparty credit risk compared to future contracts.
Prior to the internet revolution finding a counterparty for trading the forward contracts was a
very difficult task (Brooks, 2010). Its mandatory for the contracts to be reversed before they
are due. Considering that the two parties can only deal with each other the terms of the
contacts tend to be unfavorable. The details of the contract are privileged only to the two
parties and they have no obligation to release the information to the public domain. An
example of the forward contract is a scenario where a farmer wishes to sell 1000 cattle in a
year time. to avoid price fluctuations, he goes ahead to enter into a contract with a financial
institution to sell the cattle and fix the price now. When the duration expires he is free to sell
at the predetermined price irrespective of the current market situation (Kothari, 2001).
Future Contracts
Future Contracts resemble the Forward Contracts in that they both necessitate the sale of a
commodity at a date in future. The sale price is though determined now. the difference
between the two is that futures contracts are listed in the exchange market. The exchange acts
as an intermediary, making the contracts to be of a standard nature and the agreement
inflexible. Contracts listed in exchange have a pre-designed format, size and expirations.
Considering that the contracts are traded on the exchange, they tend to adhere to a daily
settlement procedure (Frank Partnoy and David A. Skeel, 2007). With this gains and losses in
the settlement are settled daily which assist negate counterparty credit risk. In this case rather
than the buyer and the seller entering into a contract with one another they enter into a
contract with the exchange. An example of a future contact is when an oil company enters a
contract that will see them get a supply of petroleum at a price determined in the present time
during the future time let’s say one to two years to come.
Option Contracts
The third derivative will be option contacts. This option is different from the first two in that
it is asymmetrical. The contact binds one party while the other is free to make a choice later.
The party that has the option of making a choice pays for the privilege in terms of a premium.
Option contracts come in two types call option and put option. In the call option the right
allowed is to buy something at a date in future. On the other hand, put option avails the right
to sell something later. The price is though predetermined. When an individual buys an

option contact they have access to four options. This can either be the short or long side of
either the put or call option. The similarity between the option and futures contracts is that
they are both tradeable in the exchange. An example of the option derivative is the
speculation (Myers, 2003). This is where an investor expects the stock price to fall soon. So,
to mitigate the risk of capital loss they buy put option on the stock.
Derivatives play a vital role in financial risk management. Increasing trading in the CDS has
enabled banks to transfer credit risks to the insurance companies. This means credit default
swaps can be applied as a tool for hedging risks (Alkeback, 1999).
Ways in which derivatives protect against the IFE and PPO failings
The current international market has become very sophisticated. The IFE and PPPO have
failed to offer solutions for some of the risks hurting investors. Interest rate fluctuations,
shifts in currency exchange rates, shifting global demand and supply for goods and services
are examples of the risks investors face. The introduction of derivatives has enabled provision
of global diversification in the currencies and financial instruments. With this, skilled
investors can generate profits from the situations that were previously regarded as risks.
The introduction of derivatives has enabled investors to take advantages such as price
discovery. This gives them room to speculate future price variations and take appropriate
measures in time (Söhnke M. Bartram, 2011). with the price discovery comes risk
management. Hedging and speculation enabled investors to take actions that assist them to
navigate through risky investments situations.
References
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comparison. Journal of International Financial Management and Accounting, 10(2), pp. 105-120.
Brooks, D. M. C. a. R., 2010. Advanced Derivatives and Strategies". Introduction to Derivatives and
Risk Management. 8th ed. s.l.:Mason, OH: Cengage Learning.
Frank Partnoy and David A. Skeel, J., 2007. The Promise And Perils of Credit Derivatives. University of
Cincinnati Law Review, 75(1), p. 1019–1051.
Hull, J. C., 2006. Options, Futures and Other Derivatives. 6th ed. New Jersey: Prentice Hall.
Kothari, W. R. G. a. S., 2001. How Much do Firms Hedge with Derivatives?, s.l.: s.n.

Lejot, Q. L. a. P., 2013. Debt, Derivatives and Complex Interactions". Finance in Asia: Institutions,
Regulation and Policy. , New York: Routledge.
Lyon, C. O. H. a. L. S., 1923. The Theory of Hedging. Journal of Political Economy, 31(2), pp. 276-287.
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83(1), p. 253.
Söhnke M. Bartram, G. W. B. a. J. C. C., 2011. The Effects of Derivatives on Firm Risk and Value.
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