Derivatives: Financial Instruments for Risk Management and Speculation

Derivatives
Derivatives are financial instrument/contract which derives its value from the underlying
securities. Under these instruments contract are entered for future date to purchase a security
on a specific date at a specific price. Major use of derivatives are in commodity sector such as
oil, gasoline etc. The other asset class where derivative is common is Foreign Currency or
currency and also there is derivative trading on stocks and bonds also.
The volume of derivative trading has increased since its inception and has gained its
popularity in the developed market stock exchange. The major purpose of derivative trading
has been detailed here-in-below:
(a) Hedging Tool and risk Management: Derivative are one of the most common used tool
for the purpose of hedging against any future uncertainty and provides a reliable
assurance of an estimated cash flow in future; (Study.com, 2019)
(b) Speculation: Derivatives are used for speculation and gain from arbitrage.
(c) Wider Exposure: Under derivatives, there are wide range of underlying securities
encompassing equity, fixed income securities, market indices, commodities etc.
(d) Determination of Underlying Asset Price: Instruments are frequently used to determine
the price of securities.
(e) Market Efficiency: Derivatives increase the efficiency of financial market and helps in
bringing liquidity in the market. (CFI Education Inc, 2019)
(f) Accessibility to unavailable asset or market: Interest rate swap are used to obtain
favourable rate of borrowing for the company.
The company that have been using the derivatives for hedging their exposure has been
detailed here-in-below:
(a) RBC
(b) CIBC
(c) Shopify
(d) National Bank of Canada;
(e) Bell
(f) Manulife etc
A common usage of derivatives have been seen among these entities. Some of the common
instruments have been detailed here-in-below:
(a) Exchange Rate or Currency derivative: This is one of the most common used financial
instrument and are used for hedging against currency movements. These derivative is
mainly used for Multinational Enterprise to hedge against the currency exposure when
goods are sold at multiple location at multiple currency. For instance, Company A is a
MNC having its export to Europe and India then such company has exposure of Euro and
INR against CAD. Accordingly, to hedge against such exposure company may choose to
use forward contract whereby a fixed rate is determined initial handed so that there is a
certainty of amount to be received in the future. (The Hindu, 2019)
In addition, the other objective of companies behind using the instrument may be to gain
from arbitrage by engaging in speculative activities on the basis of estimation and news.

Suppose, going long on Euro expecting it to rise, the company can go long on Euro and
short on CAD, thereby making arbitrage gain.
(b) Interest Rate Derivative or Interest Rate Swap: Interest rate swap is an agreement entered
into between parties to exchange one method of payment of interest with other over a
defined given period. These instrument can be exchange traded or over the counter. The
most common form of Interest Rate derivative is plain vanilla whereby a company swap
a fixed rate coupon interest for a variable rate of interest. Suppose, ABC is an entity
situated in Canada wishes to take loan in variable interest benchmarked to LIBOR or any
other benchmark. However, fixed rate of interest bearing coupons are only available. In
this case, company may take coupon bearing loan at fixed rate and may enter into a swap
with another party for received fixed rate of interest equal to coupon and pay floating
rate of interest. Another instance of swap can be when company is hoping that floating
rate of interest shall be lower compared to fixed rate of interest. Company under this
situation may switch to variable rate by entering into an agreement with the third party.
(PIMCO, 2019)
(c) Commodity Derivative: This instrument is generally used by producer companies to
hedge against the product price volatility. These instruments helps the companies to
budget their production and take vital strategic decision on future course of action for the
company. Commodity swap shall range from metals, minerals to agriculture. These
instruments help companies to choose a particular fixed price for products to be sold in
future. These hedge helps to protect producer against a sharp fall in prices of commodity
in future, Suppose, an entity ABC is engaged in producing/ growing of wheat, the
company may hedge its exposure of future volatility by entering into a commodity
derivative and fixing price and computing the profitability accordingly. (Financial
Pipeline, 2019)
The company may also use these instruments for the purpose of speculation and shall
earn arbitrage gain from difference in buy and sell price.
(d) Equity Derivatives: This derivative is not commonly seen in the balance sheet of non-
financial companies and is used to leverage the exposure to equity as the equity
derivatives generally trade at 1/10th the price of equity shares. Further, it can be used to
hedge risk bv going long or short on contracts. (What are Equity Derivatives?, 2019)
The companies selected for analysis encompass the following:
(a) Accord Financial – Torrento Stock Exchange;
(b) Starbucks Corporation- NASDAQ;
(c) Aegon NV- NYSE
Brief Profile of companies
Accord Financial – Torrento Stock Exchange
Accord Financial Corp is a provider of asset backed financial services to business
encompassing lending on the basis of assets, factoring, and protection of credit and