Why Do Companies Use Derivatives?

Why do companies use derivatives? How can these be beneficial to a company? How can they hurt a company?

Derivatives are used by a company to hedge risk. Risk can come in different flavors and so can derivatives.

There are three main risks, which are hedged using derivatives. The first is interest rate risk. Many seemingly good investments can suffer at the hands of the fluctuations in interest rates. There are a few ways to hedge interest rate risk, one being a long-term lock on the interest rate by purchasing a treasury future and another is to use an interest rate swap whereby the company literally swaps their payment obligations by "swapping" a variable rate payment for a fixed rate.

A second risk is exchange rates. If a company bids on a contract to sell a product for a fixed price, 6 months in the future but be paid in a currency different from their own, they run the risk of the exchange rate between the two currencies changing to their detriment resulting in the company receiving a relatively lower fee in their home currency. To hedge against this risk, companies can buy foreign exchange futures AGAINST the change in the exchange rate, which would positively affect the outcome for them and thereby providing them with insurance against the negative change.

The third risk example is that of a commodity risk. Many products have dependent input commodities such as fuel, raw material etc. whose prices are critical in the company's final profit. A company that signs a contract to provide a certain amount of their product in the future for a specific price, can be negatively effected and even have a negative profit if their input commodities rise in cost.

We can see the benefits that these derivatives can provide to companies, by hedging their risk and providing a safety net should things not go as planned but there