How Can Derivatives Be Used for Risk Management?

Reviewed by Gordon Scott

Derivatives are financial instruments whose value is derived from other assets like stocks, bonds, or foreign currencies. They are often used to hedge a position (protecting against the risk of a loss) or to speculate on future moves in the underlying asset.

Hedging is a common form of risk management in financial markets. Investors use derivatives to protect certain positions or even entire portfolios, while companies use them to protect their exposure to the price of assets—usually currencies or commodities—that are central to the cost of their business operations.

Key Takeaways

• Derivatives are financial instruments whose values are tied to other assets like stocks, bonds, or currencies.
• Hedging is an investment strategy intended to protect a position from losses.
• Common derivatives used for risk management include options, futures, forwards, swaps, and credit-default swaps (CDS).
• Each derivative type serves specific risk-management purposes—options provide flexibility, futures and forwards lock in prices, swaps exchange cash flows, and credit-default swaps transfer credit risk.

What Are Derivatives?

Derivatives are financial instruments whose value is tied to an underlying asset, index, or financial variable. Unlike direct investments in stocks or bonds, derivatives establish contractual relationships between parties to transfer or manage specific risks. These tools serve two primary purposes:

• Hedging: Protection against negative price moves
• Speculation: Attempting to profit from market movements

The derivatives market comprises different instruments that address specific ways to manage risk:

• Exchange-traded derivatives are standardized contracts traded on regulated exchanges with centralized clearing, providing transparency and liquidity.
• Over-the-counter (OTC) derivatives are customized agreements negotiated directly between parties, offering flexibility but potentially less liquidity and transparency.

While some derivatives, such as futures and options, are often used by retail investors, others, such as interest rate swaps or credit derivatives, are primarily employed by institutional investors, corporations, and financial professionals.

Using Futures To Manage Risk

Futures contracts are standardized agreements to buy or sell a specific asset at a preset price on a particular date. Unlike options, both parties in a futures contract must fulfill the terms of the agreement, making them less flexible for managing risk.

Futures contracts create a direct hedge by locking in prices, transferring the risk of price changes from one party to another. They are standardized with fixed quantities and delivery dates, making them easily tradable on regulated exchanges.

Most often used by companies, they’re often employed in two ways:

1. Short hedge (selling futures): Protects against price drops in assets already owned or that the company will soon produce. Manufacturers commonly use this strategy.
2. Long hedge (buying futures): Guards against price increases in assets needed for future operations. This approach is favored by companies that need to ensure they can afford their inputs at a later time.

Example: Suppose a wheat farmer is concerned about potential price declines before harvest. At planting time, wheat futures are trading at $7.50 per bushel for delivery after harvest. The farmer is happy with that price, so they sell futures contracts to cover the crop, locking in the price.

Futures positions are “marked to market” daily, requiring those trading them to maintain margin accounts that can handle any price moves.

Financial Futures

Financial futures extend the ability to hedge beyond physical commodities. Bank managers might use Treasury futures to manage interest rate exposure, while portfolio managers might use stock index futures to hedge market risk without selling their underlying positions, such as shares in index funds.

Options for Hedging Risks

The buyer of an options contract holds the right but not the obligation to buy (calls) or sell (puts) an underlying asset at a preset price (the strike price) within a specific time frame. This payoff structure means that those managing risk can carefully balance the risk-reward ratio of their holdings.

Unlike futures or forwards that lock in prices with firm obligations, options function more like insurance policies. The premium paid protects against negative price moves while keeping open the possibility of profits. This flexibility comes at a cost—the premium is paid upfront regardless of whether the option is eventually exercised.

Protective Strategies Using Options

Protective put strategy: You would buy put options to establish a floor price for an asset such as a stock that you own. This strategy caps your downside risk.

Covered call strategy: Investors who own an asset can sell call options against their position, generating income that can offset small price declines or increase returns in flat markets. The trade-off is limited upside beyond the strike price.

Collar strategy: Combines protective puts with covered calls by using the premium from selling calls to partially or fully offset the cost of purchasing puts. This creates a range of protected prices with limited cost but also caps potential gains.

Beyond Equity Options

While options on stocks are the best-known, using these derivatives to manage risk goes well beyond equities:

• Interest rate options: Protect against rate fluctuations while maintaining flexibility if rates move favorably.
• Currency options: Hedge foreign exchange exposure while preserving potential benefits from currency movements.
• Commodity options: Like commodity futures, these allow companies to protect against changing costs, but without committing to fixed prices if market conditions improve.

Interest Rate Swaps

Investors use interest rate swaps to exchange interest payment streams, with one party who has a fixed rate trading for a floating rate. The underlying debts aren’t affected.

Here are some key strategies used:

• Fixed-to-floating swap: Converts fixed-rate obligations to a floating rate.
• Floating-to-fixed swap: Lock in current rates against potential increases from a floating rate.
• Basis swap: Exchange payments tied to different floating rate benchmarks.
• Forward-starting swap: Secure future rates for expected financing needs.

Example: A company with floating-rate debt concerned about rising rates enters a swap to pay fixed rates and receive floating rates, converting it to a fixed-rate loan.

Currency Derivatives

For international operations, currency derivatives help manage foreign-exchange exposure through forwards, futures, options, and swaps tailored to specific needs.

Here are some key strategies used:

• Forward hedge: You agree today on an exchange rate for a future transaction, such as locking in $1.10 per euro for a payment you’ll receive in three months.
• Option hedge: You pay for insurance that protects against negative moves in exchange rates while letting you benefit if rates improve.
• Money market hedge: You borrow in one currency and convert to another to avoid the risks of future exchange rate moves.
• Natural hedge: You work to match the currency of revenues with the currency of expenses, where possible.

Example: A U.S. exporter expecting a payment of 5 million euros in 90 days can use a forward contract to lock in the current USD/EUR exchange rate, eliminating uncertainty about the dollar value they’ll receive.

Credit Default Swaps

Credit derivatives transfer default risk without selling the underlying asset, functioning similarly as insurance against borrower defaults.

Here are some key strategies used:

• Direct protection: A firm buys CDS on specific issuers to hedge existing exposure.
• Portfolio protection: An investor uses a CDS basket to hedge diversified credit portfolios.
• Proxy hedging: Protect against correlated credits when direct CDS isn’t available.
• Curve trading: Manage exposure across different time horizons using a term structure.

Example: A bank holding large corporate loans can buy CDS to transfer default risk while maintaining client relationships and continuing to service the loans.

Key Aspects of Risk Management With Derivatives

Derivative-based risk management requires a systematic approach that includes the following:

1. Identify the specific risks that could materially affect a company or portfolio.
2. Select the right derivative instruments to address the exposures you’ve identified.
3. Determine an optimal hedge ratio (the amount of derivatives you’ll buy for the capital at risk) based on risk tolerance and market outlook.
4. Check positions regularly to ensure they align with your objectives.
5. Assess their effectiveness by later comparing the outcomes with your initial hedging goals.

Perfect hedges rarely exist—considerations include basis risk (differences between derivative and physical market movements), transaction costs, and the operational complexity of maintaining hedge positions.

How Do Futures Contracts Work as a Hedging Tool?

Futures contracts provide a straightforward way to lock in prices today for future transactions, effectively transferring price risk to another party. For example, an airline concerned about rising fuel costs can buy jet fuel futures, guaranteeing today’s price for future delivery no matter how the market price changes.

When Should You Use Options Over Futures for Hedging Strategies?

Options are generally thought to be more flexible when a company is less sure about how much or when the price of something will change. Unlike futures, which create obligations, options give the right but not the obligation to execute at the strike price, acting as price insurance, with the price of the options as the premium.

This approach is particularly worthwhile for businesses bidding on international contracts with foreign-exchange risks. If they don’t win the contract, they can let the options expire.

When Are Interest-Rate Swaps Used for Hedging?

Interest rate swaps allow companies to strategically convert between fixed and floating rate exposure without refinancing existing debt. For example, a company with a strong balance sheet, but with concerns about rising rates, may consider swapping floating-rate debt for fixed-rate payments, locking in current rates for the duration of the swap. Meanwhile, organizations confident in their ability to weather short-term volatility might swap fixed obligations to floating rates to capitalize on potential rate decreases.

The Bottom Line

Derivatives help manage the risks from the shifting costs investors and companies face, whether they concern the stock market, how much fuel will cost in six months year, or changes in currency exchange rates or interest rates.

Rather than speculating on market directions, prudent hedging involves identifying core risks, selecting the right derivative for those risks, and using a disciplined approach that treats hedging as an integral part of risk management.