Role of Financial Derivatives in Risk Management

Abstract

The word risk is termed to different meanings to different people (Adams, 2014). There is disagreement about the meaning of word risk among people. The word risk is used by the people to address different terms (Rajic, 2015). Johansen and Rausand (2014) stated that you would probably receive the various responses upon asking the people what they meant by the word risk. Aven and Renn (2009) described the risk term as an event with uncertainty and severity and outcomes of an activity that human value. Rajic (2015) defined the risk term as the probability of injury to an employee. So, risk is a situation where actual outcome deviate from expected outcome. Risk is categorized into two forms such as internal risk and external risk. Internal risks are controllable while external risks are not in our control. Risk management refers to the process of understanding, mitigation and sharing of risk. Risk management plays a key role in the financial industry and an integral part of it. Markets and risk management practices grow with the progress of business. The growth of the business and market expansion pose challenges for managing the risk. As a result, financial instruments evolved to manage the risks which are known as financial derivatives. Rao (2012) stated that derivatives are contracts where the yields of contracts depend upon on underlying value. The underlying can be an interest rate, commodity or currency. Emira Kozarevic et al. (2014) defined the derivatives as securities whose values depend upon the underlying assets. The assets can be a commodity, bond, foreign exchange rate, stock and weather disaseters (Hanic, 2014). Malleswari (2013) stated that there are different forms of contract but most common forms include futures, forwards, options and swaps.