Financial Risk Management and Derivative Instruments
Financial risk management
This domain covers forwards, futures, options, swaps, caps, floors and collars, and the hedging of FX and interest-rate risk.
Core rules
- Forwards lock a future price and are customised; futures are standardised and marked to market.
- Options give the right, not the obligation, to buy or sell; the buyer pays a premium.
- Interest-rate swaps exchange fixed and floating payments; caps set a maximum rate, floors a minimum, collars combine both.
- Hedging reduces uncertainty but not necessarily profit; it may forgo upside.
- Interest-rate parity and purchasing-power parity link spot, forward, inflation and interest rates.
Worked example
A Sri Lankan exporter expects USD 1m in three months. Spot is LKR 300/USD; the three-month forward is LKR 305. A forward hedge locks in LKR 305m. If spot at maturity is LKR 290, the forward is better by LKR 15m; if spot is LKR 315, the forward is worse by LKR 10m. The hedge removes downside but also removes upside. A put option would protect the downside while retaining upside, at the cost of a premium.
Traps
Do not say hedging eliminates all risk; do not ignore basis risk; do not hedge a forecast exposure without confirming it is genuine; and do not compare a forward with an option without accounting for the premium.