Check out this exploration of the most common types of financial derivatives!
In this video we are going to talk about Types of Derivatives. I love talking about this stuff. It’s so interesting, but more than that, Derivatives can be valuable financial tools for organizations. So what I am going to do is go through a list of different types of Derivatives, and what I want you to notice is there is a common theme, and it has to do with Risk.
As businesses grow, company leadership becomes more and more concerned with managing risks. What are the things that could happen that could interrupt company cash flow? Now there are two types of risk in every business:
- The risks inside the business control
- The risks outside the business control
A risk inside the business control could be something like equipment breaking down. Well that is a risk a business leader can mitigate through having a backup plan, storing spare parts, and training staff.
A risk outside the business control is like the global currency market. There is nothing a business can do to control that, but for a business that operates across country borders, currency risk can dramatically impact company profits.
So here is the central concept I want to communicate: Financial Derivatives allow businesses to hedge away risks outside the business’ control.
To see how this happens, let’s talk about Currency Derivatives. You can buy a contract that enables you to exchange currencies at a set price at some point in the future. So let’s use an example. Let’s say you are a US company, and you are planning on doing a large project in Europe. Part of this contract is going to require you to engage in contracts with local companies in Europe, and those contracts are going to be written in Euros. Well as a business manager, one of the things you will be watching closely is the exchange rate between the dollar and the Euro. As that exchange rate fluctuates up and down, it is going to be effecting your profits, with no bearing on whether you are actually doing a good job on the project. You could be losing money purely because of shifts in the exchange rate. So what the financial derivative does, is it removes this risk out of the profit calculation. At the beginning of the projects when you sign the contracts with the European suppliers, you also purchase the derivative, so you can pay the contracts at a set exchange rate. Now the business can focus on executing on the thing they can control: running an effective project. And the risks they can’t control are moved into the derivatives market where there are buyers looking to add that level of risk/return to their portfolios.
So here is a list of some of the different derivatives, but they all function on the same theme. I am listing out the name and the risk they help mitigate:
Commodity futures: crops, metals, oil, gold prices
Options: stock prices
Interest rate swaps: variable vs. fixed interest rate
Credit default swap: loan default
Mortgage backed security: foreclosure
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.