Types of Risk Management Derivatives
Rather than an obscure financial tool, derivatives are actually an important part of business. Businesses use derivatives as a component of their risk management or insurance strategy to hedge some of the most volatile aspects of the economy. Businesses use a few types of risk management derivatives, which are particularly interesting.
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Cash Flow Hedge
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One use of derivatives is to hedge future cash flows. Large businesses that sign big contracts use puts and calls in the bond market to ensure that the value of their future cash flow is maintained. In addition to purchasing these on a regulated exchange, large banks and financial firms such as General Electric and Bank of America will issue companies derivatives -- ensuring steady cash flow.
Currency Derivatives
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Firms use currency derivatives to protect against the risk of a change in currency values. In particular, firms use them with imports, exports and foreign profits. For example, if a U.S. firm has a contract to sell an airplane to a Japanese firm in three months. The U.S. firm would lock in its sales price by selling a contract of Japanese yen worth the same as the product sale price. When the sale date arrives, the company would simply buy the contract back into the open market, eliminating its currency risk.
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Supply Hedging
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Supply hedging uses derivatives to protect against fluctuations in supply costs. Airlines are one user of derivatives to protect their risk of rising oil prices used for fuel. Rather than let the price of fuel be left up to the vagaries of the market, an airline will lock in its prices by hedging on futures exchanges. When the airline needs the fuel, it simply sells back the contract and uses the proceeds to purchase the oil based on the prevailing price.
OTC vs. Exchange Traded
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Business derivatives can be both over the counter and exchange traded. Over-the-counter derivatives are much more volatile, provide a high profit margin to the seller and are much less actively trade. On the other hand, they can be customized for a business' specific need. For example, they can exactly match a sales contract a business has with a cash hedge on the contract. Exchange-traded derivatives are much more frequently traded but do not provide the same customization.
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References
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