Derivatives There Are a Number Essay

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A swap is arranged between counterparties who can set the terms of the swap. A bank is usually one counterparty but as with forwards it does not have to be. The swap is settled with an exchange of the difference, rather than the full flows. Companies typically use swaps to manage interest rate exposure, for example when they have a floating rate loan in a foreign country. If a company has a Chinese subsidiary that borrows from the Industrial and Commercial Bank of China, but is concerned about inflation in the country because the yuan pegging distorts interest rate parity, it can use interest rate swaps to hedge this risk by locking in the amount it will pay to settle the floating rate loan, even though the rate might change in the interim.

Options include puts and calls, which are rights to buy or sell a given asset (usually a stock) at a specific point in time. Investors often use these to either hedge a position to place a bet on the stock's movement.

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An interest rate collar covers interest rate fluctuations on the high and low end. A company using this technique would purchase the right to cap the rate paid on an increase, and sells the right to a payment if the rate declines. Companies like banks that hold bonds use this technique to lock the value of that bond within a specific range. A floor can be sold that gives the bank a premium right away. If the rate drops below the floor, the bank does not see that profit, but the counterparty who bought the floor would benefit from the interest rate drop.

Conclusion

There are a number of different types of financial derivatives that are used to hedge risk. The use of each type varies by the underlying asset and the desired objective of the counterparties. It is important for firms doing international business -- or working with commodities -- to understand how best to use each type of hedge in order to mitigate their risks.

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