Introduction
There is a need for great wisdom on the concept behind ideal credit risk reduction tools for the investors domestic and world exposures in , Futures and Options, Consequently, the building interest in calculating credit default probabilities was by no means then limited to the highly industrialized countries like the United States, Europe, Thailand, Australia to name a few. However, it is now spreading all over the world at a rate that surprises even the third world countries. People have developed great enthusiasm in these tools to protect their interest in the form of investments.
Realtech System Plc. is a SME enterprise that provides technical equipment and services to the water industry. The business has been successfully growing over the last decade but has found trading difficult in the last two years due to supplying companies in a regulated industry. This has led to the business being reliant on short time borrowing at this time but the outturn as £35m. It addressed that they could not obtain as favourable terms as usual w
ith the bank and they had to pay a rate of LIBOR +2%.
To hedge the risk exposure some derivatives can be used by the management. These are forward rate agreement, Swaps, Option, Future contracts and etc. These can reduce the risks but in sometimes have some risks to hedge. The risk of using of derivatives is given below in context with Realtech Systems PLC;
When the option is used the company may be faced with risk exposure, if there is zero value. As the firm needs short term financing, it should go for floor trading and of the stipulated price is less than anticipated the firm may incur with no loss if the stock is hold. But the requirement of short term financing is hampered. So, the liquidity position may get worse. It is same in put and call option
At the time of using forward rate agreement, if the market price of deliverable instruments is falling down below the stipulated rate, it may face with loss and the requirement of short term financing. It is same if the firm act as a seller except the price is increasing.
Risks of using Derivatives