Exapling the hypothetical
example of using derivatives to hedge against risk.
John is a maize grower and wants to sell his maize in two
weeks’ time.
The current market price is $5 per kilogram, but it
fluctuates daily.
John makes a ‘forward’ derivative contract with maize buyer,
Kigen.
The contract stipulates that Kigen will buy 100 kilograms of
maize from John at $5 per kilogram in two weeks’ time.
With this contract in hand, John protects himself against
the potential risk that maize prices may fall, knowing he will be able to sell
his maize at the guaranteed price of $5 per kilogram in two weeks.
Similarly, Kigen hedges against the risk that maize prices
may increase.
Thus, this ‘forward’ contract between John and Kigen is an
example of using derivatives as a hedge or risk management tool.
The contract has made John’s and Kigen’s cash flows more
predictable because John knows he will receive $500 for 100 kilograms of maize
from Kigen in 2 weeks’ time, and Kigen knows he will receive 100 kilograms of
maize for $500, no matter how much the market price for maize changes in the
meantime.
The value of the contract derives from the performance of
maize prices, hence the name derivative.
If the market price
for maize unexpectedly increases to $8 per kilogram, then the derivative
contract is more valuable to Kigen because he will still be able to buy maize
at a bargain price of $5 per kilogram from John, as stipulated by the contract.
Conversely, if the price unexpectedly decreases, the contract is more valuable to John, because he will be able to sell the maize at an above-market price.
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