What it means
The four everyday types are forwards, futures, options and swaps. A forward or future locks in a price for a future date, an option gives the right but not the obligation to trade at a set price, and a swap exchanges one stream of payments for another, most commonly a floating interest rate for a fixed one.
The commercial purpose for ordinary companies is hedging rather than speculation. A bakery that buys wheat, an importer that pays suppliers in another currency and a borrower on a floating rate loan all face a price they do not control, and a derivative converts that uncertainty into a known number.
The value of the contract moves with the underlying price, which is the whole point and also the whole danger. A hedge that gains when your input cost rises will lose when that cost falls, so the correct way to judge it is alongside the exposure it covers rather than on its own.
Derivatives are often described as risky, and used without an underlying exposure they certainly are, because a modest deposit can control a very large notional amount. Used to cover a real exposure of matching size and timing, they reduce risk rather than adding it.
Accounting for derivatives is more demanding than the trading itself. Contracts are carried at fair value with changes running through profit unless the business formally documents them as hedges, which is why smaller companies often prefer simple forward contracts with their bank over anything more elaborate.
In practice
Real-world examples.
Example
An airline buys fuel futures covering 60% of its expected consumption for the next twelve months. When fuel prices spike, the futures gain offsets most of the extra cost at the pump, allowing the airline to hold its published fares for the season.
Example
A UK exporter invoicing US customers in dollars sells its expected dollar receipts forward at a fixed rate. The contract removes the risk that a stronger pound turns a profitable order book into a loss-making one between invoice and payment.
Example
A property developer with a $12,000,000 floating rate loan enters an interest rate swap, paying a fixed rate and receiving the floating rate. Its interest cost becomes predictable, which is what the project's investors required before committing funds.
Formula
Calculation
For a simple forward contract, the gain or loss at settlement is: (settlement price - contracted price) x quantity, from the point of view of the buyer.
A wire manufacturer needs 100,000 pounds of copper in six months and cannot absorb a price rise. Copper trades at $4.20 per pound, so the company enters a forward contract to buy 100,000 pounds at $4.20, a notional value of 100,000 x $4.20 = $420,000.
Six months later the market price is $4.65 per pound. Buying the copper on the open market costs 100,000 x $4.65 = $465,000, while the derivative produces a gain of ($4.65 - $4.20) x 100,000 = $45,000. Net cost = $465,000 - $45,000 = $420,000.
If instead the price had fallen to $3.90, the open market purchase would cost 100,000 x $3.90 = $390,000 and the derivative would show a loss of ($3.90 - $4.20) x 100,000 = -$30,000, giving a net cost of $390,000 + $30,000 = $420,000 again. Either way the manufacturer pays $420,000, which is exactly what a hedge is meant to achieve.Case study
Seen in the real world.
The following is a fictional, illustrative example. Alderpoint Chocolate, an invented confectionery maker, priced its Christmas range in March based on cocoa at prevailing market levels and committed those prices to three national retailers for the whole season.
Cocoa prices rose sharply over the summer. Because the finance director had bought forward contracts covering 80% of the expected cocoa requirement, the company's average input cost rose by only a fraction of the market move, and the fixed retail prices remained profitable.
The illustrative complication came the following year, when the same approach was applied to 130% of expected volume. Prices fell, demand was weaker than forecast, and the surplus contracts turned a hedge into a speculative loss of $310,000. The fictional company's own review concluded the mistake was hedging more than the real exposure, not using derivatives at all.
Watch out
Common mistakes.
- Judging a hedge in isolation and calling it a failure whenever it shows a loss, when a loss on the contract paired with a lower input cost is the hedge working exactly as designed.
- Hedging more than the underlying exposure, which quietly turns risk management into speculation on a market the business has no expertise in.
- Ignoring the cash flow effects, since margin calls on futures can demand real cash long before the offsetting saving on the physical purchase ever appears.
Questions
People also ask.
What is the difference between a forward and a future?
A forward is a private contract negotiated with a bank and tailored to your dates and quantities, while a future is a standardised contract traded on an exchange with daily cash settlement.
Do small businesses ever use derivatives?
Yes, most commonly as simple currency forwards or fixed rate swaps arranged through their own bank, which cover a genuine exposure without any trading expertise.
What does notional value mean?
It is the size of the underlying exposure the contract refers to, such as $420,000 of copper, and it is not the amount of money at risk or the amount you have to put up.
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