Huge Organizations use the derivatives very freely. But even the small firms can benefit from the derivatives. Basically economic benefits of the derivatives do not depend on the institution size that is trading the derivatives. The decision of using the derivatives should not be on the basis of size of the company but by the strategic objectives.
The actual risk management strategy role must be for ensuring the required funds are made available to the value increasing investment opportunities. But, it is very vital that each and every user of the financial derivative irrespective of the size , have the knowledge of the how the contracts are structured, risk characteristics and unique price of the instruments, how will they be able to perform in volatile and stressful conditions.
A far sighted risk management strategy needs to be the one that confirms the corporate goals and complete with the stress tests and market simulations is a very important prerequisite of using the financial derivative products.
The worth of financial derivatives market is more than dollar 20 trillion on a regular basis. This estimate not only dwarfs the bank capital but the nation’s dollar 7 trillion annual GDP (Gross Domestic Product). These frequently quoted figures are the notional amounts. In case of financial derivatives, the notional principal is actually the amount in which the interest and the other types of payments are dependent. Generally the notional principal does not change the hands; it is just a quantity that is used for calculating the payments.
Whereas the notional principal is a commonly used measure in financial derivatives market, it’s not accurate for measuring the credit exposure. The useful proxy for actual exposure of the derivative instrument is the replacement cost and credit exposure. The exposure is the replacing cost of the contract at the current market value in case if the counterparty defaults before the date of settlement.
For 10 largest financial derivatives players in the U.S.A. bank holding company, the derivative credit exposure has an average of 15% of the total assets. For the bank loan portfolios, the average credit exposure is 49% of the assets. In short, if the 10 banks lose 100% on loans, the loss can get 3 times more than expected if there’s a replacement of all their derivative contracts.
The financial derivatives is also a key factor in improvising the market efficiencies as the risks can be sold and isolated to he people who are willing as well as ready to accept at the least costs. The added advantage of using the financial derivatives is that the same breaks the risks in pieces so that they can be independently managed. The corporations can decide which risks they can comfortably handle and keep these kinds of risks and transfer the risks that cannot be managed by them to other type of companies that are readily accepting them. If you look at the perspective, the financial derivatives offer free trading of the financial risks.
The feasibility of the derivatives lies on the comparative advantage principle. The comparative advantage means the cost of holding the specific risks. Therefore, whenever there is an existence of the comparative advantage, all the parties that are involved can benefit from the trade. The financial derivatives also allow free trading of the individual risk component.