Financial Risks, as we have already covered in this lecture how derivatives such as forward contracts, futures contracts, and swaps can be used to hedge financial risks. A first step in risk management is to use the process described previously in assessing risk, keeping in mind that a cost/benefit analysis for each feasible alternative is a must.

Hedging with futures contracts as it applies to financial risk involving the CBOT contract on US Treasury Bonds. Treasury bond contracts are 20-year contracts, $100,000 with a 3.5 percent coupon.

Futures contracts can be used for both speculation and hedging. Note the distinction: Speculation involves betting on future price movements (futures are used because of the leverage inherent in the contracts); and, hedging is done by a firm or individual to protect against a price change that would otherwise negatively affect profits. Both parties to a futures contract can be hedgers (a natural hedge) or one party can be a speculator and the other a hedger. Note also that there are two basic types of hedges: (1) a long hedge in which futures contracts are bought in anticipation of (or to guard against) price increases; and (2) a short hedge where a firm or individual sells futures contracts to guard against price declines.

Futures markets were established for many commodities long before they began to be used for financial instruments.

If derivatives help in minimizing the variability of cash flows, this would help reduce the possibilities and related costs of financial distress.

1. Question: If this holds true, why do more large firms use derivatives than small firms?