Derivative markets

Over the last 30 years, fluctuations in interest rates , currencies and the prices of raw materials have become so great that financial risks have become as important as industrial risks. Consider a Swiss company that buys copper in the world market , then process es 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, be cause it uses the dollar to make purchases abroad and receives payment in dollar s 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. the bumper sticker says, ‘‘if you think education is expensive.

Take an example of an economy with no derivative market s. A corporate treasurer anticipating a decline in long-term inter est rates and whose company has long-term debt has no choice but to borrow short-term invest the proceed 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, intermediate costs rise and so on. Derivative markets enable him to manage this long-term inter est-rat e risk without touching his company’s balance sheet. 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 mate rial – 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.

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