The exciting world of derivatives

The main purpose of any business is to increase shareholder wealth. In doing this, a business has to take risks. It is possible for a business to manage risks and protect itself against undesirable outcomes. Derivatives are often used to hedge certain risks faced by a business. So, what is a derivative and what common risks are hedged using derivatives?

Derivative is a financial instrument whose price is derived from one or more underlying. There is a contract between two or more parties though the initial investment is relatively low. The underlying could be stocks, bonds, commodities, interest rates, foreign exchange rates etc. As the price of the underlying moves, the valuation of derivative changes. Derivatives can be used for speculative purposes, but they are best used to hedge risks.

Derivative contracts are often used to hedge interest rate and currency risks. Interest rate swaps are used to convert fixed rate exposure to floating rate exposure or vice versa, depending on the risk management objective of the business. As the interest rates move, the valuation of the related swap also changes. Forward contracts are used to manage foreign exchange risk. If a business has amounts receivable or payable in foreign currency in the future, it is possible to fix the amount that would be received or paid (net) in the local currency by entering into a forward contract. Hedging interest rate and currency risks also helps business manage its cash flows. For this reason, if used appropriately, derivatives can be invaluable tools for a business to manage risks over which they have no control.