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Use of Financial Derivatives

1. Performance objective:

(a) How do companies use financial derivatives to manage some of their risks?
(b) Identify several types of derivatives.
(c) Why use an options contract rather than a forward contract?
(d) Why let a put option expire; why exercise a call option?
(e) Are swap agreements traded internationally? If so, then provide an example.

2. Problem-solving: Identify and describe two financial management practices that firms use to manage each of the following:

(a) liquidity risk;
(b) interest rate risk; and
(c) credit risk.

Solution Preview

1a. Companies could use derivative as an insurance (hedging) purpose. For example: a US energy company would hedge the uncertainty of the profit they will receive from overseas by entering currency forward agreements to limit losses due to uncertainty in the exchange rate between two currencies.

b. Futures, Interest and currency swap, Options, Forward, warrants.

c. Options contract will give you a right to purchase/sell the underlying assets at certain price; forward contract will give you an obligation to purchase/sell the underlying assets at certain price that has been ...