Derivatives

trade a given asset at a set price on a future date. These are "price-fixing" agreements that saddle the buyer with the same price risks as actually owning the asset. But normally, no money changes hands until the delivery date, when the contract is often settled in cash rather than by exchanging the asset.

Q: In business, what are they used for?

A: While derivatives can be powerful speculative instruments, businesses most often use them to hedge. For instance, companies often use forwards and exchange-listed futures to protect against fluctuations in currency or commodity prices, thereby helping to manage import and raw-materials costs. Options can serve a similar purpose; interest-rate options such as caps and floors help companies control financing costs in much the same way that caps on adjustable-rate mortgages do for homeowners.

Q: Why are derivatives potentially dangerous?

A: Because these contracts expose the two parties to market moves with little or no money actually changing hands, they involve leverage. And that leverage may be vastly increased by the terms of a particular contract. In the derivatives that hurt P&G, for instance, a given move in U.S. or German interest rates was multiplied 10 times or more.

When things go well, that leverage provides a big return, compared with the amount of capital at risk. But it also causes equally big losses when markets move the wrong way. Even companies that use derivatives to hedge, rather than speculate, may be at risk, since their operation would rarely produce perfectly offsetting gains.

Q: If they are so dangerous, why are so many businesses using derivatives?

A: They are among the cheapest and most readily available means at companies' disposal to buffer themselves against shocks in currency values, commodity prices, and interest rates. Donald Nicoliasen, a Price Waterhouse expert on derivatives, says derivatives "are a new tool in everybody's bag to better manage business returns and risks."

SOURCE: Lee Berton, "Understanding the Complex World of Derivatives," The Wall Street Journal, June 14, 1994. Excerpted by permission of Dow Jones & Company, Inc. via Copyright Clearance Center, Inc. © 1994 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

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