Use of Derivatives - Chapter 5

This is a similar question to the one regarding Bond Futures, but a bit more general so I didn't want to post it in that topic.

I understand the general nature of each of the types of Futures, Swaps and Options in Chapter 5, but want to know why these are used by companies - and think I need to remove my CT1 hat to figure them out.

From what I understand, companies aren't playing the stockmarket or looking to make extra profit, but rather are removing the uncertainty that arises from fluctuations in share prices, interest rates, exchange rates, etc. Is that correct?

It seems that most/all of the instruments means the company may miss out on potential profit. E.g. the example of a company being paid $100m in a year's time - the company can essentially lock in today's exchange rate to guarantee they exchange it for £60m in a year. As such they ensure they won't be exposed to drops in exchange rate, but they also won't benefit from increases in exchange rates.

Thanks

 

It depends what companies you are talking about. Derivatives are a zero-sum game. In other words, for every person who makes a profit there will be someone else on the other end of the contract who will make an equal loss. For every company that wants to reduce risk, you need someone else willing to take on that risk for a contract to exist. Hedge funds make extensive use of derivatives to increase their exposure to risk, for example.

In contracts such as futures and forwards, you are correct that if you use them to reduce risk then you reduce upside potential as well (you lower your variance). However, options contracts allow you to pay a premium to retain the upside potential and just get rid of the downside risk.

To use your example, the company could pay a couple of million dollars for the option to exchange their $100m for £60m in a year, but without the obligation to do so. So at the end of the year, if they could only get £50m in the market, they can use their option to get £60m. However if they could get £70m in the market, then they can just let the option expire and do that, and all they lose is the initial premium they paid.

 

Thanks for the reply. The further I've gone in the notes the more familiar I've got with the concept.

Another question, which plays off the back of your comment about having to find someone that was willing to sell the option, is whether there is always a party willing to enter into the future/option/swap agreement. The notes treats the topic as if finding a party is a given, but I'm wondering how these things work in the real world.

Thanks