Financial contracts and exposures. Operational technique.
A financial contract is a legally binding agreement between two or more people. It allows for the exchange of performance in return for financial compensation. A variety of risk types can be managed with financial contracts, such as credit, liquidity and market risks.
Market risk refers to fluctuations in an asset’s value due to economic changes such as change in interest rates, currency exchange rate, commodity prices, and equity prices. These exposures are managed by financial contracts like futures, options and forwards. Both buyers and sellers agree to buy or sell assets at a certain date, at a fixed price. Futures are a way of committing. The forwards and options are identical but can be customized with regard to the delivery date or size of the trade. Buyers have the ability (but not obligatory) to sell or buy assets at predetermined strike rates on or before their expiry dates.
Credit risk arises when one party fails to fulfill its contractual obligations due to either insolvency or defaulting on payment obligations; this affects the counterparty’s ability to receive its payments as agreed upon in the contract. Swaps, debt securities, and guarantees are financial contracts that transfer credit risk from one party to another.
In liquidity risk, contractual payments can’t be honored due to insufficient access/availability cash resources. It results from mismatches of assets/liabilities maturities and unexpected withdrawal/demands for funds from depositors. You can manage this risk using repurchase agreements. These agreements allow you to buy back any securities previously sold. If sufficient funds have been secured, other similar instruments are collateralized loan arrangements which guarantee loans with specified collateral.