Risk Management Techniques

Paper Summary:

This paper reviews the history of risk management techniques and goes on to discuss the risk management techniques of today. The paper then takes a look at the distinction between forward contracts and futures, discussing the various advantages and disadvantages, hedging techniques, trading of futures and options, and risk exposure.

Outline:
Brief History of the Evolution of Futures and Options
Difference between Forward Contracts and Futures and the Limitations of Forward Contracts in Risk Management
Advantages and Disadvantages of Using Futures and Options as Risk Management Tools
Futures as a Hedging Technique in Different Industries - Farmers, Agriculture, etc.
Trading Futures and Options
Differences between Hedgers and Speculators
Different Types of Options -Straddle, Strangles, Exotic, etc.
The Possibility of Buying and Selling Weather Derivatives and How This Help Certain Industries Reduce Their Risk Exposure

From the Paper:

"Disadvantages of Options. Just like futures, options involve risk of loss and may not be suitable for use by everyone. A wise analysis of its response in the market performance is a must. Trading futures and options involve basis risk. This kind of risk can only be eliminated by incurring marginal transaction costs such as broker's fees, opportunity costs, hidden costs of illiquidity, and learning costs. However, these costs of trading options are much higher in percentage basis as compared to trading the underlying stocks, which may lead to exhaustion of profits. Since options can be traded in any underlying stocks, it becomes complex and would require maintenance otherwise it may cause difficulty in trading. Due to poor liquidity, there is a risk not to recover an investment in buying or selling options in a stock for speculative gain. A higher amount of premium may be required because of uncertainty in the cash market, thus will render hedging of the option more difficult. It is also very explicit that options are time-sensitive, thus, there is a possibility that it may expire worthless. There is also a tendency that the buyer may lose the entire premium since options are wasting asset if it still remains out-of-money until the expiration date. Like futures, the seller has to face the risk of being assigned exercise in random by the stock exchange."

Sample of Sources Used:

• Anderson, John D. and Greg Ibendahl. University of Kentucky Cooperative Extension Service. (2000). "Risk Management Tools for Dairy Farmers: Options on Dairy Futures". Retrieved on March 23, 2006 from http://www.uky.edu/Ag/AnimalSciences/extension/pubpdfs/aec86.pdf
• Anyadike, Nnamdi. (2004). Woodhead Publishing Limited. ISBN 1 85573 591 1. "Aluminium - The challenges ahead". Retrieved on April 04, 2006 from http://www.woodheadpublishing.com/en/book.aspx?bookID=298 .
• Arditti, Fred D. Harvard Business School Press. (ISBN 0875845606). "Derivatives: A Comprehensive Resource for Options, Futures, Interest Rate Swaps, and Mortgage Securities."
• Ark Group Ltd. (1994-2005). "Risk Management: The Development of Hedging". Retrieved on April 4, 2006 from http://www.gold.org/value/markets/supply_demand/derivatives.html
• Associated Press. (1998, April 4). "Bill Would End Ban on Commodities." National press release.

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