The term derivative is used often in the world of finance, and few outside the world know what a derivative is. This video introduces the idea of derivatives and how they are used.
- Let's suppose you're going on a vacation to Costa Rica. That would be awesome. The currency in Costa Rica is called the colon. It was one of the most beautiful currencies in the world. So you've planned ahead, and booked a villa six months from now. The cost of the villa for the week is 550,000 colones. That sounds like a lot, but don't panic just yet as the exchange rate currently is about one US dollar equals 570 colones. That converts to about 965 US dollars, payable when you get there.
But the risk to you is that exchange rate will change between now and when you go on your trip. And depending on which way the exchange rate goes, you could end up paying more or less than 965 US dollars, perhaps significantly more. And that brings us to the topic of derivatives. A derivative is a contract that derives its value from the movement of the price, exchange rate, or interest rate on some underlying asset or financial instrument. Now, most firms use derivatives as a tool for managing risk.
Those risks include the following, price risk, that's the uncertainty about the future price of an asset. Credit risk, the uncertainty of whether the party on the other side of an agreement will abide by the terms of the agreement. Interest rate risk, the uncertainty about future interest rates and their impact on future cash flows as well as on the fair value of existing assets and liabilities. And exchange rate risk, the uncertainty about future US dollar cash flows arising when assets and liabilities are denominated in a foreign currency.
That's the risk apparent in our Costa Rica vacation example. Now, all of these risks relate to the future and we know some risk is an unwanted side effect of doing business, but there are ways to mitigate these risks. In our Costa Rica example, we can eliminate the risks of a changing exchange rate by simply denominating the transaction in US dollars, let's just pay in dollars. Well that might be good for us, but that's simply throws the risk of a changing exchange rates to the renter of the villa.
She or he is now exposed to the risk of changing exchange rates, and they may or may not agree to that change. Another option is to simply buy 550,000 colones today and hold them for six months and then use those colones to pay for your vacation villa, but that ties up your money for six months. And another option is to use a derivative financial instrument. In this case, we would call that derivative a hedge. We are hedging against the risk of future exchange rate changes.
We would contact a currency broker who's in the business of buying and selling all sorts of world currencies and we would contract with them to purchase 550,000 colones six months from now. We would lock in the price today of what we would be paying six months from now and a currency broker will do this, for a fee naturally. We will pay that fee to eliminate the risk of exchange rate changes. This would be called a derivative transaction.
Simply put, we are paying something akin to an insurance premium. With insurance premiums, we pay the insurance company money to mitigate the financial risks to us should something go bad. If I have a medical issue, the costs to me are lower because my insurance company will pay much of the cost of treatment, and I pay the insurance company a monthly premium to reduce the upside risk to me. In our Costa Rica case, you pay a currency broker a fee, so that you know today what your vacation villa will cost you six months from now.
Derivative instruments well-used push the risk of interest rate changes or exchange rate changes, or price changes to someone willing to bear that risk, again for a fee. The potential issue with derivative financial instruments, is when they are not well-used. As you might imagine, derivatives can get quite complex and can be frequently misunderstood, even by corporate treasures and portfolio managers. For example, Barings PLC, Britain's oldest merchant bank, charted in 1762, put out of business through the misuse of derivatives.
Proctor & Gamble, a big US consumer products company, lost 195 million dollars in a derivatives deal gone bad. The CEO at the time stated after the fact that the officials who bought the derivative we're like farm boys at a country carnival, they had no idea. But know this, derivative financial instruments when well-used, can protect companies from unwanted risks of business. That's their purpose.
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