CHAPTER 33

DERIVATIVES FOR MANAGING FINANCIAL RISK

Q.1.
A.1.

What are derivatives? Why do companies hedge risk using derivatives?

A derivative is a financial instrument whose payoffs are derived from some other
asset which is called an underlying asset. Option, an example of a derivative
security, is a more complicated derivative. There are a large number of simple
derivatives like futures or forward contracts or swaps. Derivatives are tools to
reduce a firms risk exposure. A firm can do away with unnecessary parts of risk
exposure and even convert exposures into quite different forms by using
derivatives. Hedging is the term used for reducing risk by using derivatives.
There are several advantages of better risk management through hedging:
Debt capacity enhancement
Increased focus on operations
Isolating managerial performance

Q.2.
A.2.

How can options be used to hedge risk? Illustrate your answer.

An option is a right to buy or sell an asset at a specified exercise price at a
specified period of time. Option is a right and does not constitute any obligation
on the part of the buyer or seller of the option to buy or sell the underlying asset.
A foreign currency option is a handy method of reducing foreign exchange risk.
Similarly, options on interest rates and commodities are quite popular with
managers to reduce risk. Many options trade on option exchanges. However, in
practice, banks and companies strike private option deals.
Let us consider an example. Suppose ONGC sells oil to Indian
Petrochemical Limited (IPCL). ONGC wants to protect itself from a potential fall
in oil prices. What should it do? It should buy a put option a right to sell oil at a
specified exercise price at a specified time. ONGC will be able to protect itself
from falling prices and at the same time benefit from increase in the oil prices.

Q.3.

Define forward and future contracts? What are the differences between forward
and future contracts?
A forward contract is an agreement between two parties to exchange an asset for
cash at a predetermined future date for a price that is specified today. Forward
contracts are flexible. They are tailor-made to suit the needs of the buyers and
sellers. You can enter into a forward contract for any goods, commodities or
assets. You can choose your delivery date for any quantity of goods or
commodities Future contracts are forwards contracts traded on organized
exchanges in standardized contract size.
It is true that future contracts are no different from forward contracts as
they serve the same purpose and operate through a contract between
counterparties. The difference is in terms of standardization and method of
operation. Futures contracts have standardized contract size and they trade only
on the organized exchanges.

A.3.

Q.4.
A.4.

What is the difference between commodity futures and financial futures? What is
the relationship between spot and future prices of the financial futures?
Futures are traded in a wide variety of commodities: wheat, sugar, gold, silver,
copper, oranges, coco, oil soybean, etc. Commodity prices fluctuate far and wide.
For large buyers of a commodity whose prices swing downward and upward,
there are significant cost implications. These companies reduce their risk of
upward movements in prices by hedging with commodity futures.
There are firms which do not have commodity prices exposure but they
have significant exposure of interest rates and exchange rates fluctuations. These
firms can hedge their exposure through financial futures. Financial futures, like
the commodity futures, are contracts to buy or sell financial assets at a future date
at a specified price. Financial futures, introduced for the first time in 1972 in the
USA, have become very popular. Now the trade in financial futures far exceeds
the trade in commodity futures.
The relationship between the stop and the future prices will be as follows:
Futures price = Spot price (1 + rf ) t dividend foregone
Spot price =

Q.5.

A.5.

Future price Dividend foregone

+
(1 + rf ) t
(1 + rf ) t

Consider the following two strategies. Strategy 1: Buy gold at spot price today
and hold it for six months. Strategy 2: Take a long position on the gold futures
contract expiring in six months. Lend money at risk-free interest rate that will be
equal to the futures price in six months. Show the relationship between the spot
price and the futures price.
In case of commodity futures, there is no dividend forgone. Further, the buyer of
commodity futures does not need to store commodity as delivery will be in the
future. Therefore, he avoids storage cost. Also, the buyer does not have
commodity on hand which does not give him a comfort or convenience of
meeting sudden requirements. Thus, the buyer saves storage cost but loses in
terms of convenience yield. The spot and futures prices relationship in case of
commodities futures is given as follows:
Future price
Storage costs Convenience yield
Spot price =

+
t
(1 + rf )
(1 + rf ) t
(1 + rf ) t
Storage costs Convenience yield
Future price

=
Spot
price
+

t
t
(1 + rf ) t
(1
+
r
)
(1
+
r
)

f
f

The difference between the present value storage costs and convenience
yield is net convenience yield (NCY). In practice, it can be inferred as the
difference between the present value of futures price and spot rice.

Q.6.
A.6.

Define a swap. Illustrate how interest rate swap helps to reduce risk exposure?
A swap is an agreement between two parties, called counterparties, to trade cash
flows over a period of time. Swaps arrangements are quite flexible and are useful
in many financial situations. Two most popular swaps are currency swaps and

interest-rate swaps. These two swaps can be combined when interest on loans in
two currencies are swapped.
The interest-rate swap allows a company to borrow capital at fixed (or
floating rate) and exchange its interest payments with interest payments at
floating rate (or fixed rate).The interest rate swaps can be used by portfolio
managers and pension fund managers to convert their bond or money market
portfolios from floating rate (or fixed rate) to synthetic fixed rate (or synthetic
floating rate).
Q.7.
A.7.

What is a currency swap? How does currency swap reduce exposure to risk? Give
an example.
Currency swap involves an exchange of cash payments in one currency for cash
payments in another currency. Most international companies require foreign
currency for making investments abroad. These firms find difficulties in entering
new markets and raising capital at convenient terms. Currency swap is an easy
alternative for these companies to overcome this problem.
Currency swaps are a form of back-to-back loan. For example, an Indian
company wants to invest in Singapore. Suppose the government regulations
restrict the purchase of Singapore dollars for investing abroad but the company is
allowed to lend rupees abroad and borrow Singapore dollars. The company could
find a Singaporean company that needs Indian rupees to invest in India. The
Indian company would borrow Singapore dollars and simultaneously lend rupees
to the Singaporean company.