Derivative Markets

Over the last 3 decades, fluctuations in interest rate, currencies and the prices of the raw materials have become so much that financial risks have become as important as industrial risks. Consider a Swiss company that buys copper in the world market, then processes it and sells it in Switzerland and abroad.

Its performance depends not only on the price of copper but also on the exchange rate of the US dollar vs. the Swiss franc, because it uses the dollar to make purchases abroad and receives payment in dollars for international sales. Lastly, interest-rate fluctuations have an impact on the company’s financial flows.

A multi-headed dragon! The company must manage its specific interest-rate and exchange-rate risks, because doing nothing can also have serious consequences.

Take an example of an economy with no derivative markets. A corporate treasurer anticipating a decline in long-term interest rates and whose company has long-term debt has no choice but to borrow short-term, invest the proceeds long-term, wait for interest rates to decline, pay off the short-term loans and borrow again. You will have no trouble understanding that this strategy has its limits. The balance sheet becomes inflated, intermediation costs rise and so on.

Derivative markets enable him to manage this long-term interest-rate risk without touching his company’s balance sheet. Derivatives are instruments for taking positions on other instruments, or ‘‘contracts’’ on ‘‘contracts’’. They let you take significant short or long positions on other assets with a limited outlay of funds.

Derivative instruments are tailored especially to the management of these types of financial risk. By using derivatives, the financial manager chooses a price – expressed as an interest rate, an exchange rate or the price of a raw material –that is independent of the company’s financing or investment term.

Derivatives are also highly liquid. The financial manager can change his mind at any time at a minimal cost. Similarly, options enable the investor to take advantage of leverage with a limited outlay of funds, but entail higher risks.