Derivatives There Are a Number

Derivatives

There are a number of different types of financial derivatives, used to hedge different situations. Often, the underlying asset and the type of risk will dictate the ideal instrument for the hedge. Some of the different types of derivatives are futures, forwards, swaps, and options. At times, in particular with options, multiple derivatives positions are utilized simultaneously. This paper will discuss the different types of derivatives and the uses for each.

Derivative Types and Uses

The first type is the futures contract. A futures contract is an agreement, entered into today, to buy or sell an underlying asset in the future (Investopedia, 2012). The futures contract typically involves delivery of the asset, rather than cash settlement, although the latter does occur. The future price of the asset is determined at the time of the contract. Futures are commonly used in commodities and currency markets. They are frequently used as hedges by firms with an interest in that asset. Airlines, for example, use futures to hedge their exposure to jet fuel price fluctuations (Graham, 2012). Airlines use crude as a proxy hedge, since there is no futures market for jet fuel. Futures are typically exchanged on organized markets and come in set denominations.

Another type of derivative is the forward contract. Forwards are usually agreements between two parties and are not exchanged on organized markets. This allows the parties to negotiate terms of the contract to meet their specific needs. Forwards can be written for any asset, but are usually only written for interest rate and foreign exchange rate risk. The forward determines the price at which the asset will be traded at a future date. Cash settlement of the difference is the norm. Forwards use often written with the company's bank as the counterparty. A company using a forward might have a specific financial flow upcoming and wish to lock in the rate today to reduce exposure. As an example, Starbucks might receive an annual franchise fee from its partner in Japan on the 1st of February, paid in yen. It could set up a forward today with its bank to lock in the value of that payment today if it feels that the yen is going to decline over that period.

Interest rate swaps are also designed to mitigate risk associated with financial flows -- interest rate risk and foreign exchange rate risk. A swap is arranged between counterparties who can set the terms of the swap. A bank is usually one counterparty but as with forwards it does not have to be. The swap is settled with an exchange of the difference, rather than the full flows. Companies typically use swaps to manage interest rate exposure, for example when they have a floating rate loan in a foreign country. If a company has a Chinese subsidiary that borrows from the Industrial and Commercial Bank of China, but is concerned about inflation in the country because the yuan pegging distorts interest rate parity, it can use interest rate swaps to hedge this risk by locking in the amount it will pay to settle the floating rate loan, even though the rate might change in the interim.

Options include puts and calls, which are rights to buy or sell a given asset (usually a stock) at a specific point in time. Investors often use these to either hedge a position to place a bet on the stock's movement. An interest rate collar covers interest rate fluctuations on the high and low end. A company using this technique would purchase the right to cap the rate paid on an increase, and sells the right to a payment if the rate declines. Companies like banks that hold bonds use this technique to lock the value of that bond within a specific range. A floor can be sold that gives the bank a premium right away. If the rate drops below the floor, the bank does not see that profit, but the counterparty who bought the floor would benefit from the interest rate drop.