HOW IT WORKS (EXAMPLE):

Foreign-exchange risk is similar to currency risk and exchange-rate risk.

Foreign-exchange risk is the risk that an asset or investment denominated in a
foreign currency willlose value as a result of unfavorable exchange rate fluctuations
between the investment's foreign currency and the investment holder's domestic
currency.
Holders of foreign bonds face foreign-exchange risk, because those types of bonds
make interest and principal payments in a foreign currency. For example, let's
assume XYZ Company is a Canadian company and pays interest and principal on a
$1,000 bond with a 10% coupon rate in Canadian dollars (CAD). If the exchange rate
at the time of purchase is $1 CAD: $1 USD, then the 10% coupon payment is equal
to $100 Canadian, and because of the exchange rate, it is also equal to US$100.
Now let's assume a year from now the exchange rate is 1:0.85. Now the bond's 10%
coupon payment, which is still $100 Canadian, is worth only US$85. Despite
the issuer's ability to pay, the investor has lost a portion of his return because of the
fluctuation of the exchange rate.

WHY IT MATTERS:
Foreign-exchange risk is an additional dimension of risk which offshore investors
must accept. As a result, open positions in non-dollar-denominated items may need
to be closed. Though foreign-exchange risk specifically addresses undesirable
movements that might result in losses, it is possible to benefit from favorable
fluctuations with the potential for additional value above and beyond that of an
already-stable investment.

How can derivatives be used

for risk management?
Derivatives could be used in risk management by hedging a position to protect
against the risk of an adverse move in an asset. Hedging is the act of taking
an offsetting position in a related security, which helps to mitigate against
adverse price movements.

A derivative is a financial instrument in which the price depends on the

underlying asset. A derivative is a contractual agreement between two parties
that indicates which party is obligated to buy or sell the underlying security and
which party has the right to buy or sell the underlying security.
For example, assume an investor bought 1,000 shares of Tesla Motors Inc. on
May 9, 2013 for $65 a share. The investor held onto his investment for over
two years and is now afraid that Tesla will be unable to meet its earnings per
share (EPS) and revenue expectations.
Tesla's stock price opened at a price of $243.93 on May 15, 2015. The
investor wants to lock in at least $165 of profits per share on his investment.
To hedge his position against the risk of any adverse price fluctuations the
company may have, the investor buys 10 put option contracts on Tesla with a
strike price of $230 and an expiration date on August 7, 2015.
The put option contracts give the investor the right to sell his shares of Tesla
for $230 a share. Since one stock option contract leverages 100 shares of the
underlying stock, the investor could sell 1,000 (100 * 10) shares with 10 put
options.
Tesla is expected to report its earnings on August 5, 2015. If Tesla misses its
earnings expectations and its stock price falls below $230, the investor could
sell 1,000 shares while locking in a profit of $165 ($230 - $65) per share.
What Are Derivatives?
An instrument whose structural characteristics and variables are based on the structural
characteristics and variables of other more basic underlying instruments. These structural
characteristics and variables include -- amount and timing of cash flows; maturity and expiration
dates; and exposure to interest rate, credit, prepayment, valuation, and exchange rate risks.
Derivative instruments include, forwards, futures, options, swaps, caps, ceilings, floors, collars, etc.
Active Derivative Markets
The markets with derivative instruments most commonly used by institutional entities include:
Treasury Bills, Notes, and Bonds.
Mortgage-backed securities.
Equity securities and related indexes.
Global currencies.
Energy (crude oil and derivative products, natural gas, electricity).
Commodities (traditional grains, softs, metals, etc.).
Why Use Derivatives?

There are two main reasons for the use of within derivatives within a risk management program:

1.

High and variable levels of market volatility. These conditions have existed since the mid
1970's.

2.

Limited ability to adequately manage risk exposure by just using policy decisions and cash
market transactions.

Exchange Traded vs. Over-The-Counter (OTC)

There are two main forums within which derivatives trade - organized exchanges and over-thecounter (OTC). They are similar in many respects, but do have important distinguishing features as
illustrated in the following table:

FEATURES

Over-The-Counter

Exchange Traded

Examples

Forwards, Caps, Floors, Collars,

Swaps, etc.

Market

Networks consisting of market makers Organized exchanges in Chicago, New

who exchange price information and York, Kansas City, and other capital
negotiate transactions.
markets around the world.

Custom-tailored to meet specific

Agreements needs of counter-parties within
accepted guidelines.
Risk

Standardized contracts.

Default/credit risk to the counterparties.

Guaranteed contract performance.

Not formally regulated.

U.S. exchanges regulated by

Commodity Futures Trading
Commission (CFTC).

Varies by market - some have

electronic posting, others require
individual inquiry and valuation.

Daily settlement and intra-day prices

electronically posted.

Regulation
Ability to
Value

Futures and Options.

Unique Terminology
One of the most significant obstacles to overcome in the use of derivatives is getting a good handle
on the use and meaning of the unique phrases utilized by market participants. The list is extensive,
therefore, please refer to Glossary for a more detailed treatment of this issue.
Strategic Applications of Derivatives
Derivatives, like most tools, are neutral until utilized. It is with utilization that positive and negative
attributes can identified. The main utilization issue related to the use of derivatives is the use to which
management is applying derivative strategies - hedging or speculating. Hedging is generally
perceived to be good and speculating is generally perceived to be bad. However, there are three
thoughts that should be kept in mind when considering these generalizations:

1.

Hedging rationale and the related documentation is oftentimes cleverly utilized to disguise
speculation. Therefore, the real issue is how to properly distinguish hedging from speculating.
This is more difficult than it would appear. Many would point to a textbook description to
describe an appropriate hedge. Textbook descriptions are just that. They are used to illustrate
hedging concepts and principles. Real time implementation, under changing market
conditions, has considerably more imperfections than what can be adequately described in a

textbook illustration. However, these imperfections are not justification for speculating. They
are simply an additional risk that management must learn how to manage. The key to
distinguishing between hedging and speculating rests in management's discipline in
consistently applying the precepts outlined in the foregoing risk management process
discussion.

2.

Speculation is an inherent part of human behavior and when managed properly can produce
very constructive results. However, some entities are precluded, by regulations or internal
policies and procedures, from speculating with derivatives. The paradox of this is that these
same entities, for the most part, are allowed to speculate through policy decisions and cash
market transactions. And, furthermore, are, in effect, speculating when they are not hedged.
Therefore, the issue becomes one of knowing when and how to properly speculate as a
function of the business and regulatory environment within which the management activity is
taking place.

3.

Regardless of whether management is hedging or speculating, there is one very dominant

consideration inherent in both - prudent management of the risks associated with the
underlying activity.