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Lesson 1 of 6 · 12 min

Benefit 1: transferring risk and creating new exposures

Derivatives let you allocate, transfer or reshape exposure to a price today, without trading the underlying itself, which closes the timing gap between an economic decision and the moment you can act in the cash market.

In short

Issuers and investors often make an economic decision before they can trade in the cash market. A derivative agreed today at a fixed price bridges that timing gap.
Derivatives move price risk across time and to the participants who are willing and able to carry it.
Issuer examples: buying inputs before sales are known, paying for imports in a foreign currency later, fixing the cost of debt before refinancing.
Investor examples: acting on a view without cash on hand, and deciding today how to reinvest a future coupon, dividend or principal repayment.
Derivatives can also build payoff profiles that do not exist in the cash market, such as a covered call.

The timing gap

Spot prices are the main information people use when deciding to buy or sell. The problem is that the decision and the trade often happen at different times. A firm may commit to a price today but only receive or pay the cash weeks later.

During that gap, the price of the underlying can move against the firm or investor. A derivative agreed today, for settlement at a future date and at a pre-agreed price, removes or reshapes that exposure without trading the underlying now.

This is the first and broadest benefit of derivatives: they let participants allocate, transfer and manage risk. Forward commitments and contingent claims shift price risk across time and towards those who want to hold it.

Issuer: a food producer must order grain months before it knows its sales volume.
Issuer: an importer will pay a foreign supplier in USD when the goods arrive, so it cannot convert its home currency yet.
Issuer: a company wants to fix the interest cost of new debt that will replace a bond maturing next year.
Investor: a fund wants exposure to a market now but its cash arrives next month.
Investor: a pension fund decides today how to reinvest a large coupon payment it will receive in three months.

The derivative is traded at the moment of the decision, so the price risk in the gap is passed to a counterparty instead of being carried by the firm.

Hedging an export receivable with an FX forward

A Norwegian machine builder, Fjordtek AS, has costs in NOK. It sells a machine to a Japanese customer for JPY 280,000,000, payable on delivery in 90 days. Until then Fjordtek is long JPY and short NOK.

If the yen weakens (more JPY per NOK), the JPY 280 million buys fewer NOK. The exposure is a loss when the JPY/NOK rate rises and a gain when it falls.

Fjordtek sells JPY forward at $F_0(T)$ = 14.00 JPY/NOK, locking in 280,000,000 / 14.00 = NOK 20,000,000. Whatever the spot rate in 90 days, the forward's gain or loss exactly offsets the change in value of the receivable.

In NOK millions against the locked-in NOK 20m. The receivable loses when the yen weakens (rate rises); the forward gains by the same amount, so the combined position is flat at zero.

Read the quote carefully: JPY/NOK = 14.00 means 14 yen per krone. A higher number is a weaker yen, which hurts a firm that will receive yen.

Creating exposures the cash market cannot

Derivatives do more than offset risk. Combined with cash positions, they can create payoff shapes that no cash instrument offers. These are built to fit a specific view of the market.

Take a covered call: an investor owns an index position and sells a call option on it. The investor collects the premium up front. In return, gains above the exercise price are handed to the option buyer, because the long index position 'covers' what the investor must pay.

This suits an investor who expects the index to stay flat or rise a little and volatility to fall. If that view is right, the premium lifts the return above simply holding the index. The price is giving up large upside.

Index bought at 2,000, call sold at X = 2,100 for a premium of 30. Up to 2,100 the covered call is always 30 better than the index alone; above 2,100 profit is capped at 130.

Formulas

Locked-in proceeds of an FX forward hedge: $\text{Home-currency proceeds} = \frac{\text{Foreign-currency amount}}{F_0(T)}$
When $F_0(T)$ is quoted as foreign currency per unit of home currency (e.g. JPY/NOK). If it is quoted as home per foreign, multiply instead.
Covered call profit at expiration: $\Pi = (S_T - S_0) + c_0 - \max(0,\, S_T - X)$
$S_0$ = price paid for the underlying, $c_0$ = premium received, X = exercise price. Maximum profit is $X - S_0 + c_0$ .

Worked examples

Example 1 Spotting the timing gap

A Spanish airline must buy jet fuel in four months, but its ticket prices for that period are set today. What is the timing gap, and how could a derivative help?

Example 2 FX forward proceeds

Fjordtek AS will receive JPY 280,000,000 in 90 days and sells the yen forward at 14.00 JPY/NOK. What NOK amount does it receive, and what would it receive unhedged if the spot rate at delivery were 15.00?

Example 3 Covered call outcomes

An investor holds an index bought at 2,000 and sells a six-month call with X = 2,100 for a premium of 30. What is the profit at expiry if the index ends at 1,900, 2,050 and 2,250?

On the exam

Expect matching items: a scenario (locking in debt costs, hedging a receivable) mapped to the benefit it shows. Covered call questions test that the seller keeps the premium but gives up upside above X.

Thinking a hedge improves the expected outcome. It removes variability; the hedged firm also gives up gains when the rate moves in its favour.
Misreading the FX quote. With JPY/NOK, a higher number means a weaker yen.
Saying a covered call caps losses. It caps gains; the premium only softens losses.

Check yourself

Q1A company wants to fix the interest cost of a bond it will issue next year to refinance maturing debt. This use of derivatives is best described as:
Q2A Swiss exporter will receive USD 2,000,000 in 60 days and sells it forward at 0.88 CHF/USD. If the spot rate at delivery is 0.84 CHF/USD, its total CHF proceeds are closest to:
Q3An investor owns an index bought at 4,000 and sells a call with X = 4,200 for 50. If the index ends at 4,500, the profit is closest to:
Q4A covered call is most suitable for an investor who expects the underlying to:
Q5Which of the following is least likely an example of an investor facing a timing gap that a derivative can bridge?

0/5Check yourself

Answer the 5 questions: +10 XP for each one you get right first time.

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