Using derivatives to hedge risk or to engage in speculation can be an effective tool for financial institutions. Financial institutions of all types and sizes can utilize derivative securities “to hedge their asset-liability exposures and thus reduce the value of their net worth at risk due to adverse events” (Saunders & Cornett, 2011, p. 696). In general, derivatives involve an arrangement that sets forth an exchange of an asset or cash flow at a set time and price in the future (Saunders & Cornett, 2011). Changes in the value of the underlying asset or cash flow affect the value of the derivative security (Saunders & Cornett, 2011). The use of derivatives is a type of off-balance sheet activity that only affects a financial institution’s balance sheet when the obligation is realized, whether through the realization of profits or expenses (Saunders & Cornett, 2011). The impact on the financial position can be positive of negative depending on the handling of the off-balance-sheet activities (Saunders & Cornett, 2011).
Derivatives come in various forms. Some common types of derivatives are various contracts (forward, futures, and spot), call options, hedges, and swaps (interest rate, currency, and credit). Although all derivative securities derive their values from an underlying asset or cash flow, each of the various types have differences that warrant discussion. Which type of derivative used can depend on the financial institution’s preferences regarding costs, ease of use, expectations within the market, specific risks to be addressed, and/or the type of financial position taken (hedging or speculation). Studies have also shown that more multinational banks along with those with higher exposure to foreign currency risk are more likely to employ derivatives as part of their risk management strategy (Yung-Ming & Moles, 2010).
The different types of derivative contracts include forwards, futures, and spots. These derivative contracts all have similarities and differences. All of the derivative contract variations involve agreements for an exchange of an asset for an amount of cash at a predetermined price (Saunders & Cornett, 2011). Additionally, they call all be used by financial institutions to hedge risks associated with performing operations.
The differences arise when the specifics of the contracts are evaluated. Spot contracts are the most simplistic of the derivative contracts. Spot contracts involve an exchange of an amount of cash today for an asset today (Saunders & Cornett, 2011). This type of contract is most often found in foreign exchange transactions where one currency is exchanged for another currency at the spot (current) rate (Saunders & Cornett, 2011). On the other hand, forward contracts involve an agreement today to pay a specific price in the future for an asset (Saunders & Cornett, 2011). Even more complexity is involved in futures contracts. These contracts involve an agreement today to exchange an asset in the future...