Derivatives critical evaluation. Evaluation of Derivative Instruments For Hedging Interest Rate Risks.

Evaluation of Derivative Instruments For Hedging Interest Rate Risks
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Introduction
Derivative instruments refer to a contract between two parties that gives the authority, obligation, and right to sell and buy the underlying asset while specifying the conditions. The type of areas specified is quantity, price, date, and variables underlying value, which the payments between the participants have to be made. Derivatives derive value from other assets such as foreign exchange, stocks, and bonds (Afza and Alam, 2011). At times derivatives can be used to speculate underlying asset future moves or hedge a position by protecting against the risk of adverse asset move.
A technique designed to eliminate or reduce the risk of adverse movement in terms of finance can be best described as hedging. When the business is not aware of what is going to happen in future, they are exposed to various risks due to the business activities and decisions they are going to make. Interest rate risk mostly exists in the asset bearing asset such as bond or loans due to the possibility of the asset value change resulting from interest change variability. Interests rate risks arise once the businesses do not know the amount of interest they are going to pay to acquire loans or bonds and vice versa. This essay will evaluate various derivative instrument and how they hedge the interest rate risk.
Effect of interest rate risk
Interest rate risks arise once the absolute interest rates levels fluctuate. The fixed-income securities value is directly affected by the interest rate risk. Since the bond prices and interest rate are inversely related, the bond prices fall due to the risk arising from the interest rate and vice versa. Long-term bond investors, especially bonds with fixed rates, are exposed to interest rate risks. Due to the exposures, the investors are susceptible to certain products such as futures, forward and options help the investors in managing the interest rate risk. As much as the bondholders are affected by the interest risk changes, the equity investors are also affected by the risks though less directly compared to bond investors. If the corporation postpones their borrowing, it will automatically result in spending less due to the unavailability of the money to spend. A decrease in spending may result in decreased profit, and corporate growth slows down, leading to low stock prices for the investors(Beets, 2004).
With any assessment of risk management, there is an option of doing nothing by ignoring which many people opt to do at times. However, unpredictability circumstances such as the rise of interest rate hedging may help in such situations by ensuring the risks are well managed, although there might be a cost to be incurred for efficient management.
For instance, the case of California Orange county in 1994 ignored the interest rate risk threat. The treasurer of the orange county lent the money at higher long-term rates while he had borrowed the same money at lower long-term rates. It was a great strategy since it brought benefits to the municipality;, the short-term rates fell due to a sustained normal curve. However, when the curve shifted to inverted yield curve status, things started to change, leading to losses. Nearly an estimated $1.7 billion losses were registered by the municipality leading to bankruptcy(Baldassare,1998). This was a hefty price that was paid by the municipality due to interest rate risk ignorance. There are various interest rate risks products that investors can choose to hedge their investments risks.
Forward contract
A forward contract is a tripartite or bipartite one on one contract which is to be performed by the parties contracting mutually on the decided contract date, terms decided upon and in future. Forward contract forms part of the basic product to manage interest rate risk management since it’s a custom...