Managing financial risks

At the outset companies have to analyse their present and future risk profile to be able to an tailor this risk profile using either linear or nonlinear financial instruments. To this end one frequently a building block approach of financial risks is employed. It leads to a portfolio of financial risks. Payoff diagrams are used to decide upon the suitable financial instruments to be used for hedging the risks. Hedges can be applied very precisely, either taking out specific component risks or reducing the risk of a whole portfolio of exposures.
Examples of linear financial instruments include stocks, bonds, futures, forwards, and swaps, while the basic nonlinear instruments are call and put options. Hedging using linear instruments implies looking for highly correlated instruments to the underlying exposure one tries to eliminate. To calculate the hedge ratio or the amount to hedge one can take the ratio of volatility of the asset concerned and the volatility of the hedge instrument times the correlation.
Derivatives can be efficient tools for managing a company´s aggregate risk profile. Often, derivative solutions are more economical and faster to execute than underlying cash transactions, and they may be custom tailored to fit a company´s objectives. Derivatives are particularly well suited for unbundling component risks and effecting macro changes in a corporate risk profile. However derivatives have to be understood and used properly.
With payoff diagrams of call and put options the desired linear or nonlinear exposure profiles can be designed. For example one construct synthetic long or short positions in the underlying to protect against negative risks by adding long or short call and put positions. This protection comes at costs (the option premiums) but one retains upside the financial potential. Linear instruments are less costly but usually imply elimination of upside and downside risks.

Options can be used effectively for strategic positioning, for example, to protect companies from adverse currency movements that may favour foreign competitors without giving away competitive upside potential. Purchasers of options have upside potential and limited downside potential. Generally, sellers of options get hurt by unexpected increases in volatility because the insurance they have sold is worth more when risk increases. Options have time value, which declines as options move closer to expiry date. Due to the nonlinear nature of options risk one needs to manage and monitor options exposures dynamically.Short option exposures are commonly managed using the Delta hedging technique. Delta is defined as a measure of the rate of change in an option´s theoretical value for a change in the price of the underlying security. However Deltas need to be continually re-estimated because there are changes in underlying rates or prices.