To determine the impact of how risk managers of Irish financial and non-financial institutions can effectively utilized derivatives contracts to hedge risk - (risk reduction)

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Adekoya, Adeniyi
Issue Date
MSc International Accounting and Finance
Dublin Business School
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Derivatives contracts (DC) which have grown world-wide can effectively be used to reduce risk through hedging strategies. Many studies, both theoretical and empirical, address the important roles of derivatives markets in an economy and this study reveals that there are positive impacts on FNFIs to use DC to hedge risks and create liquidity efficiency income that is more effective and welfare-improving method to deal with price volatility. Nevertheless, it has been established that using derivatives contracts (for instance CDS) do have negative effects, although not in Ireland but in the US, which can lead to exacerbated volatility and seldom cause crisis (financial and economic) that could amplify the negative effects and accelerate contagion as experienced in Ireland in 2008.Thus, loss venture of this derivatives for the institutions concerned has to do with the problem of application, that is, the way in which the derivatives contracts has been used (i.e. wrong motive). Perhaps, the fundamental reasons for the derivatives negative effects on risk management are associated with the leverage nature of derivatives markets transactions, the non-quantification of risks, non-setting of risks limits, non-monitoring of both, lack of information and non-transparent reporting of transaction risks, non–evaluation of the soundness of the counter-party risks, unsophisticated or insufficient risk management controls in financial and non-financial institutions, as well as weak regulatory and supervision system termed ‗light touch regulation‘. Interestingly, academic literature clearly concludes that for countries derivatives markets to fulfil the functions of risk reduction, price discovery, hedging role, redistribution of income and stabilization compared to what has occurred in established markets, countries financial systems needs to be supported by sound macroeconomic fundamentals and updated financial policies and regulations. Likewise, scholarships have argued that while there is no uniform optimal development strategy, that countries can adapt to sequence or structure their derivatives markets; gradual development schemes accounting for dynamics in different markets should be encouraged. Additionally, for an optimal productive derivatives markets to reduce risk will require more fundamental reforms that will make it possible for market participants and regulators to determine and make judgement whether the risks faced by companies and institutions have been effectively been hedged with public information available from these markets in order to avoid speculation, volatility and the building up of risks in the system. Obviously, the quantification of risk, the setting up of risk limits and the monitoring of those risk limits will assist markets participants to manage their risk. Strikingly, other vital requirements to be initiated when using the derivatives markets are: the setting up of the counterparty risk limits in the derivatives markets transactions in order to assess whether counterparty may default, the market participant exposures, borrowing conditions of the counterparty, ability to repay back their debts, the counterparty appetite for risk-taking, the liquidity and solvency status and the establishment of more Central Counter-Parties Clearing House (CCPCH) as suggested by Charlie McCreevy's for the European CDS markets which he said will undoubtedly improve the operational efficiency of derivatives contracts markets to function fully in these highly interconnected global financial markets ensuring electronic trade execution, affirmation and confirmation indeed. Author keywords: Financial and non-financial institutions, Ireland, derivatives contracts, hedging, risk management