In the course of running a business, decisions are made in the presence of risk. A decision maker can confront one of the two types of risk. Some risks are related to the underlying nature of the business and deal with such matters as the uncertainty of future sales or the cost of inputs. These risks are called business risk. Another class of risk deals with the uncertainty of such factors as interest rates, stock prices, and commodity prices. These are called financial risks.
Most businesses are accustomed to accepting business risks. Indeed the acceptance of business risks and the potential rewards that can come with it are the foundations of capitalism.
But financial risks are a different matter. The paralyzing uncertainty of volatile interest rates can cripple the ability of a firm to acquire financing at a reasonable cost, which will enable it to provide its products and services. Firms that operate in foreign markets can have excellent sales performance offset if its own currency is strong.
Companies that use raw materials can find it difficult to obtain their basic inputs at a price that will permit profitability. Managers of stock portfolios deal on a day-to-day basis with wildly unpredictable and sometimes seemingly irrational financial markets.
Although our financial system is replete with risk, it also provides a means of dealing with risk, in the form of derivatives.
Derivatives are financial instruments whose value / returns are derived from those of other financial instruments (Underlying instruments).
Derivatives can be based on any underlying;
- Metals: Precious metals: Gold, Silver, etc.. Non-precious: Tin, Zinc, Nickel, etc.
- Energy resources: Oil, Coal, Electricity, etc
- Live Cattles: Fish, Pork, etc.
- Agri Commodities: Wheat, Sugar, Coffee, Cotton, etc.
- Financial Assets: Shares, Bonds, Foreign Exchange,
Others: Weather, rainfall, snowfall, etc.