Is “derivative” a four-letter word? No, it’s a clean word without blame.
A good part of the blame for the current financial crisis is being placed on derivatives - financial contracts that derive their value from some other financial or real asset.
Derivatives can be used for both speculating and hedging. Hedging occurs any time a firm incurs a cost to reduce the risk of adverse price movements.
Firms like hedging. It makes financial planning easier, allowing managers to focus on their own production, not external forces like commodity prices, currency values or interest rates. Financial derivatives are a widely used tool for hedging. Hedging with derivatives, including futures, forwards, and swaps, involves entering a contract that will gain in value when a loss occurs in the business or real assets of the firm. Good hedges offset adverse business-price changes with a gain in the derivative contract.
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Futures contracts are sold on exchanges like the Chicago Board of Trade. They are frequently used to hedge price risks facing farmers or mining companies. For a small deposit, a farmer can protect against price declines by selling corn future contracts.
Conversely, commodity users can protect themselves from rising input costs. A flour mill can protect against price increases by buying wheat futures contracts. A cheese producer can buy milk contracts.
Most derivatives are not sold on exchanges as futures are. Forwards and swap contracts are customized to meet specific hedging needs. A forward contract is an agreement to buy or sell an asset in the future at an agreed price. But unlike standardized futures, forwards are designed specifically for the quantity and time period of the producer or purchaser.
Swaps contracts have grown very popular, particularly with many businesses now operating in numerous currencies. A swap is an arrangement between two traders to exchange a series of future payments on different terms. This hedge entails trading a possible adverse price movement, like the value of a foreign currency, for known cash flows with a party that has the opposite need.
Derivatives like these have gotten a bad rap. Many headlines alert us to losses when investors speculated in derivatives. But the legitimate business strategy of using derivatives to hedge real operational risks never makes the headlines.
Malcolm Cooper, treasury director for National Grid, a utility operator, told the BBC this week that recently proposed regulation for derivatives is “a sledgehammer to crack a nut”. Current suggestions for tightening regulation in Congress will raise uncertainty and costs to the company.
The European Commission also announced this week that it is making plans to require all traders to use standardized derivative contracts and trade them only on centralized exchanges, rather than the more widely used over-the-counter market. This will make it harder for hedgers to meet their individual needs.
Local companies could face higher costs for their hedging transactions. According to their most recent annual report, Idaho Power uses derivative contracts, like forwards and swaps, to manage exposure to “price risk in the electricity market”. The company says the objective of this program is to “mitigate the risk associated with the purchase and sale of electricity and natural gas.”
Derivatives make good business sense. Idaho Power’s program can reduce the company’s need for frequent electric rate changes to consumers and businesses. Other Idaho businesses can reduce price and interest rate risks, and thereby better manage their operations.
Boise Inc. has an extensive risk management program using derivatives. The company states in its most recent annual report that it is “exposed to market risks, including changes in interest rates, energy prices, and foreign currency exchange rates.” The company follows this by saying, “Derivative instruments are used only for risk management purposes and not for speculation or trading.”
Similarly, Coeur D’Alene-based Timberline Resources Corp. uses derivative instruments to hedge interest-rate risks on its debt.
Idaho firms are using these products responsibly.
Policymakers correctly state that more trades on regulated exchanges can make the derivative market more transparent – an important property for the efficiency of any financial market. As currently planned, however, the cost for these changes will be borne by legitimate business firms hedging their risks, not the speculators.
Don’t wash their mouths out with soap. Derivative is not a bad word.
Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.