AIA is publishing a series of articles designed to take a quick look at key topics in accountancy, management and finance. Bookmark this page to update your knowledge when you can grab a spare five minutes. If you would like to suggest subjects for future articles, please contact us.
A QUICK LOOK AT…
Derivatives are financial instruments used to hedge or to speculate on transactions in different areas of finance. Derivatives derive their value from underlying assets or factors such as commodity prices, interest-rates, or currency exchange rates and they can be used to manage risk or to reduce it.
Of the multitude of different derivative products that exist, the most relevant for the examination syllabus are currency futures and options, and interest-rate futures and options. If a company is going to receive payment in particular currency they need to buy a futures contract or contracts in that currency; and if they are going make a payment in a foreign currency in the future they need to sell a futures contract or contracts.
When a company buys or sells a future to they commit to entering into an additional transaction in the future with the intention of limiting the risk of existing contracts. Futures essentially work by entering into a transaction where the outcome will be the opposite of a transaction to which a company is already committed.
Futures contracts are not usually allowed to run to their end date but are instead “closed out” which means that they are brought to an end before the date on the contract. Futures contracts are, however, binding and if exchange rates move favourably during the contract period the company holding the future will be precluded from taking advantage of this movement.
Futures are standardised contracts available in pre-determined sized “blocks”, at pre-determined dates, in specific currencies only. Therefore, they will probably not provide a “perfect” hedge for any given transaction. They are traded on specific futures exchanges which virtually guarantees against counterparty risk.
The exchange will demand an initial margin or deposit from both sides which is placed in a client’s margin account. Each day, any profit or loss on the position is debited or credited to the margin account until the contract is closed out. This means that neither party will be hit with a sudden loss at the point of closing out.