Risk Management: Foundations for a Changing Financial World

CHAPTER 31

THE USES AND RISKS OF DERIVATIVES^ae

Joanne M. Hill

Derivative products offer a means of improving performance, controlling risk, and increasing flexibility. The use of derivatives also introduces risks, however, and those risks have been increased by the globalization of financial markets and the speed and complexity brought by technological advances. Choice among the various derivative instruments and strategies requires careful consideration of the benefits and drawbacks of each instrument. Risk management requires scenario analysis for existing strategies and internal risk-control processes.

Since their inception, derivative securities have always been controversial, and anyone involved in derivative research can expect to be on the defensive. This presentation provides a definition of derivative securities, followed by the history of their use and a discussion of why they are receiving increased attention today. The presentation then focuses on why derivatives should be considered return-enhancement and risk-management tools and looks at ways in which equity derivatives are being applied in international investing. The presentation closes with a discussion of the risks incurred in derivatives use and suggests some ways to manage this risk internally.¹

DERIVATIVES

Derivative securities allow investors to match a set of securities or portfolios to a set of risk and return opportunities. In other words, by using derivatives, investors can transform the risk-return ...