Managing Risk with Derivatives
Managing Exposure
Companies
that produce or depend on purchasing commodities are exposed to
price fluctuations that occur in commodities markets. Examples of such
companies include the airline industry, which is constantly exposed to
the price of oil, and farming, which is not only exposed to the
fluctuation in the price it can sell its goods at but also to the
fluctuation in the price of animal feed, fertilizer, pesticides, and
other such inputs.
Commodity Price Fluctuation This graph shows the price of crude oil between August 2008 and January 2009. Companies dependent on oil prices for their supply can implement hedging strategies using derivatives to manage this exposure.
Derivatives allow risk related to the price of underlying assets,
such as commodities, to be transferred from one party to another. For
example, a wheat farmer and a miller could sign a futures contract to exchange
a specified amount of cash for a specified amount of wheat. Both parties have reduced a future risk: for the wheat farmer,
the uncertainty of the price, and for the miller, the availability of
wheat.
However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond with coupon payments, a stock that pays dividends, etc.) and sells it using a futures contract.
The individual or institution has access to the asset for a specified amount of time and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the asset's future value.
Derivatives can also serve legitimate business purposes. For example, a corporation borrows a large sum of money at a specific interest rate. The interest rate on the loan resets every six months, and the corporation is concerned that it may be much higher in six months.
The corporation could buy a forward rate agreement (FRA), a contract to pay a fixed interest rate six months after purchasing a notional amount of money. If the interest rate after six months exceeds the contract rate, the seller will pay the difference to the corporation or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA reduces the uncertainty concerning the rate increase and stabilizes earnings.
Key Points
- Companies that produce or depend on the purchase of commodities are exposed to price fluctuations that occur in commodities markets.
- Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, etc. ) and sells it using a futures contract.
- Although a third party, called a "clearing house," insures a futures contract; not all derivatives are insured against counter-party risk.
Term
- Commodities – a class of goods for which there is demand, but which is supplied without qualitative differentiation across a market.
Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/options-and-corporate-finance-16/managing-risk-with-derivatives-121/index.html
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