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Financial derivatives are the hedging instruments.
Financial derivatives are used by finance manager managers to secure the
returns on investments and its value.

 

We should cover few derivatives which are commonly
used. The following are the derivatives which are used to hedge the financial
risk:

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1)     Forward contracts: Forward contracts are agreement between two
parties on future date at pre-determined price. Forward contracts are OTC –
Over the Counter forward agreements. They are highly customized because right
from small farmer to large corporates can form the contract. The lot sizes are
also customized. Forward contracts are done by producers and manufactures to
ensure the purchase and sale price attain a stability or linearity so that
bottom lines can be secured.

 

Example: Major wheat producing farmer and Kellogg form a forward
contract. Farmer can decide to sell his produce to Kellogg on some future date
and at fixed price. Say, 3 months from now at USD 100,000 per 1000 Kg of high
quality wheat. This mitigates the risk of price fluctuations for farmer and Kellogg.
However, 3 months later either of the party could be at opportunity loss.

 

2)     Future contracts: These are similar to forward contract with
same buy and sell feather but futures are exchange traded contracts (Not OTC)
the contracts are standardized (means lot size and prices are as per index).
Basic functions remain same as forward contracts. But in future market lot of
financial institutions participate along with the other producer and
manufactures.

 

Example: Suppose a company has purchased a stock. Now this stock
has huge probability of falling in future. Company can go ahead and sell the
future contracts on same stock hence this will make the asset delta neutral.
Delta neutral means if that stock falls by a unit then portfolio would lose by
one and future contract would gain by same unit. This will make purchased
securities completely hedged against market movements.

3)     Options: Options are complex derivatives. In option buyer of the
contract has option to exercise the contract or not exercising it. Premium is
minimum amount which is required to purchase option. It is like taking a term
insurance plan. Paying of premium for unforeseen event.  Types of option:

a) Call option: Buyer has expectations that the price underlying would go up.
Hence, he buys option. Seller of options has reverse expectations

b) Put options: Buyer has expectation that price of underlying would fall in
future.

 

Option hedges the portfolio at cheaper cost. Because
the premium amount is lesser than blockage of cash in future contracts. But it
has its own demerit that it becomes insensitive with passage of time and
moneyness (in the money and out of the money). Out of the money means strike price
are moving away from the present price (at the money) and no gains for the
buyer and vice versa in case of in the money.

 

The above is brief coverage on options. Let’s see an
example so that at least we can cover the hedging potential of the option and its
underlying risk.

 

Example: Lets take example that a company has bought
X stock which is of worth $ 10 million in market. Now, as per market information
that, there will be huge downfall in stock prices. It will be too costly to buy
the future contracts because of high margin. In this case risk manager can go
ahead and buy option quantity applying the hedge ratios and should capture
gamma or curvature of option. This will help make portfolio risk neutral.

 

4)     Swaps: Swaps are basically interest rate swap
contracts. Interest rate swaps can be based on same currencies or it can be
based on cross currencies. Interest rate swaps are hedging instruments. Used to
hedge interest rate movement.

Finance managers can go
for fixed to floating or floating for fixed contract. Basically, depending on
the expectations. This also called cash flow hedging or fair value hedging.

 

 

Example:
Interest Rate Swap is the contract on interest rate. The interest rate movement
is hedged here.

Let’s take A and B are
two parties. A has investment in a bond of USD 1 Million and gets fixed coupon
of 3% p.a. B has invested in a bond of USD 1 Million and earns floating
interest of 3% p.a.

A is looking to earn
floating rate as he is expecting interest rate to go up.

B is looking to earn
fixed interest rate as he wants to ensure his all future income to be stable.

Here
the expectations are totally reverse and hence eligible to form a contract.

In above article we have covered definition of
different derivative and practical example against each derivative to cover the
fact that how companies use financial derivatives to manage risk.

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