Importance of derivatives

non-financial management by companies in achieving varied positions.
A derivative is a security, the value of which depends on the value of another asset, called the underlying asset. Common types of derivatives are futures, options and swaps.
Futures Contracts
A futures contract is a standardised, exchange tradable contract between two parties to trade a specified asset on a set date in the future at a specified price. From the definition a lot of advantages are revealed. For instance, it gives the company an ability to buy, be it raw materials or services now, at a certain price the company is comfortable with, to pay at a future date. This can help companies lock in the value of their assets or liabilities, or to guarantee the value of their receipts and payments.
Local companies could use either commodity futures or financial futures to achieve this. While commodity futures are more ideal for agriculture-dependent companies, financial futures are generally ideal for any medium-sized to large exchange listed companies.
There is so much mechanics that happens by the issue of bonds or bills rather, by a company. While the bond market is not currently active, it is essential for those involved to take heed.
Let us say a company wants to issue bonds in future but wishes to lock in the current level of yields, this company could simply sell some bond future contracts at current prices in order to lock in the current yields. On the other hand, let’s say a company has afforded to be granted some huge funds despite all these liquidity challenges, but the interest rates have been staggered to increase each year which might cost the company in the long run. In this case the company can easily fix future interest payments by use of an interest rate futures contract to fund increase in the interest rates payable.
With much activity being witnessed in the mergers and acquisition market, there is high mechanics taking place both from the predator company’s point of view and the target companies as well. For the predator, during a takeover, a rise in target company’s share price can cause an increase in amount the predator has to pay. In this case buying of a stock market index futures can prove the mettle.
Currencies also pose much risk to the business especially with borders becoming more and more open through international trade agreements such as Comesa. This gives companies an option to use many of these derivatives to lock in currencies to desired levels. Forward currency markets prove to be the best for this.
Risk Management
Derivatives are generally good risk management tools because they are flexible and can easily be engineered to suit the required specific need of any company. More often than necessary, companies are left in a corner too difficult to escape because of varied situations that expose them to risk, including but not limited to rise in interest rates and depreciation of currency.
Risk in this case generally refers to the possibility that an investment’s actual return will not be as expected.
Swaps
A company can use swaps to reduce risk by matching its assets and liabilities. For example, a company with short-term liabilities linked to changing interest rates but long term fixed rate assets could use interest rate swaps to achieve a better matched position.
A swap is an agreement to exchange one stream of cash flows with another according to a formula agreed upon. Currency swaps can prove to be of use to exporting firms since they allow an exchange of a series of payments in one currency for a series of payments in another. Zimbabwe is currently a net importer and with much imports coming from China there might be need to lock the yuan by use of these instruments.
Reducing cost of debt
Companies are often faced with the decision to source for funds to boost their operational capacity. In most cases that money has to come from debt, thus it is imperative that the debt stays lucrative to investors while remaining cheap to service for the company.
Swaps are able to allow this to happen as they enable a company to borrow in the form that offers the lowest financial cost to them by swapping a whole stream of cash flows. Together let us LET FINANCE BE ENGINEERED!

Thomas Muserepwa is a Financial Engineering student at the Harare Institute of Technology and president of the Financial Engineering Society. He is currently attached at GMRI Capital.