Financial Derivatives and Risk Management

Readers Question: How and why do firms use derivatives to hedge risk?

Financial derivatives are a mechanism for managing risk. They involve options to buy or sell at a certain price in the future. This means that a firm can guarantee being able to buy or sell a contract at a certain price.

Why Firms Use Financial Derivatives.

The main reason firms use financial derivatives is that  it is way to manage risky price movements. In a way derivatives are a type of insurance and enable them to ‘hedge’ against adverse price fluctuations. This is important in volatile commodity prices or when exchange rates may be volatile.

It is ironic that financial derivatives are often considered to be ‘risky speculation’ when there intended purpose is to insure against volatile markets. Of course, derivatives can be misused by speculators. Rather than insuring against positions, derivatives can be used to gamble on a way one increase in stock markets e.t.c. But, the initial purpose of derivatives is to reduce risk.

Example of Exchange Rate Risk Management

Suppose that a UK firm needs to import raw materials from Canada and this raw material is 50% of their total cost. This manufacturing firm then sets up a contract to sell the good to a retailer for a certain price over the coming 6 months.

The exchange rate is going to be very important for determining the firms costs, but, usually this is something that they do not have control over. For example, if the Pound Sterling devalued by 25% (which is quite possible in the next 6 months), the effective cost of the raw material would rise by 25%. This could make the business unprofitable, because their retail price is less than the new cost.

To hedge against this outcome, the firm could purchase currency futures which give them the ability to buy Canadian Dollars in six months time at a fixed cost now. Therefore, even if the pound does fall, they will still be able to buy at the agreed price. If the pound doesn’t fall they just lose the relatively small premium of buying the contract.

Commodity Futures Markets

Firms may also use financial derivatives to avoid the risks of adverse price movements during periods between purchases and receiving deliveries. It is a similar type of hedging, where a parallel but opposite futures contract is taken when physical orders are made.

The Firm will buy a call option to buy a commodity at a certain commodity at a fixed price in the future. If the price of the commodity rises above this option price, then they can exercise the right to buy at a lower price. If the price of the good is below the option price they will not exercise the right. They will just lose the premium of buying the option in the first place.

By on March 1st, 2008

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