Derivatives – How Are They Used?

Computers, the Internet, and other advances in technology have dramatically increased the speed at which business happens. It seems that fortunes are made and lost at record speed, and prices can surge and plunge much quicker than ever before. It is surprising how resilient and stable the economy has been, given the pace of change. One reason companies survive unforeseen events is they use a modern form of insurance.We are all familiar with life, disability, and property casualty insurance. However, most people are not familiar with how companies use derivatives to protect their operations from all kinds of unforeseen events.

Derivatives: Insuring the modern economy:

Please do not be intimidated by the word “derivative.” You do not need a Ph.D. to understand this. A derivative is simply a contract between two parties. The value or cost to each party is “derived” from the value of an underlying stock, commodity, or market index. These derivatives may be referred to as futures contracts, swap contracts, or options. Clear as mud, right?

Let’s look at an example. Oil companies often use derivatives to lock in the future sales price of the oil they produce. Suppose it costs an oil company $70 to produce a barrel of oil. The company is highly profitable when a barrel of oil is selling for $100, but it could be devastating if the price suddenly dropped to $53. Therefore, the oil company might sell futures contracts (through a broker or bank) that lock in the price at say $87 for the next year. These contracts ensure that the oil company will be able to sell its oil at a profit, thereby providing stability to the company, its investors, and its employees. The buyer of the futures contract would likely be a big user of oil, such as an airline or manufacturer that needs to protect itself from a spike in oil prices.

Derivatives - How Are They Used?Click to enlarge

A thriving derivatives market is good for companies:

These futures contracts can be bought, sold, and traded just like a stock. Their value increases and decreases as the price of the underlying commodity (oil in our example) changes. The oil company in our example may hold its contract to expiration so it can continue to sell its oil at a profit. However, it may sell its contract at a profit if it needs the funds sooner (e.g., if its bank cuts off its line of credit).

Derivatives/futures contracts are used by almost all large companies to manage, trade, and quantify risk. Farmers use futures contracts to protect the selling price of their crops. Banks and insurance companies use them to hedge interest rate and currency risk, and money managers (like Surevest) even use them to protect against severe downturns in the stock market.

So, in general, derivatives have the potential to provide a more stable and predictable economy and also keep about 100,000 finance majors employed 🙂