What are Derivatives and the Treasury?
Derivatives are financial instruments that derive their value from an underlying asset, such as a stock, bond, or commodity. Derivatives can be used to hedge risk, speculate on the future price of an asset, or simply to generate income. The treasury is the department of a company that is responsible for managing its finances.
How are Derivatives Used in the Treasury?
Derivatives can be used by the treasury to manage a variety of risks, including:
- Currency risk: Currency risk is the risk that changes in the exchange rate will impact the value of the company’s assets and liabilities. For example, if a company imports goods from another country, it could use a currency derivative to hedge against the risk of the value of the currency it imports in falling.
- Interest rate risk: Interest rate risk is the risk that changes in interest rates will impact the value of the company’s assets and liabilities. For example, if a company has a lot of debt, it could use an interest rate derivative to hedge against the risk of interest rates rising.
- Commodity price risk: Commodity price risk is the risk that changes in the price of commodities will impact the value of the company’s assets and liabilities. For example, if a company is a food producer, it could use a commodity derivative to hedge against the risk of the price of wheat rising.
Derivatives can also be used by the treasury to speculate on the future price of an asset. For example, the treasury might buy a futures contract on oil if they believe that the price of oil is going to rise in the future. If the price of oil does rise, the treasury will make a profit on their investment.
Finally, derivatives can be used by the treasury to generate income. For example, the treasury might sell a call option on a stock if they believe that the price of the stock is not going to rise very much in the future. If the price of the stock does not rise, the treasury will keep the premium they received for selling the option.
MCQs on Derivatives and the Treasury:
- Which of the following is not a derivative?
- Futures contract
- Option
- Swap
- Currency swap
- All of the above are derivatives
- Answer: All of the above are derivatives
- Derivatives can be used by the treasury to hedge risk, speculate on the future price of an asset, or simply to generate income.
- True
- False
- Answer: True
- Currency risk is the risk that changes in the exchange rate will impact the value of the company’s assets and liabilities.
- True
- False
- Answer: True
- Interest rate risk is the risk that changes in interest rates will impact the value of the company’s assets and liabilities.
- True
- False
- Answer: True
- Commodity price risk is the risk that changes in the price of commodities will impact the value of the company’s assets and liabilities.
- True
- False
- Answer: True
Conclusion
Derivatives are a powerful tool that can be used by the treasury to manage risk and generate income. However, they are also complex instruments and should only be used by experienced treasury professionals.
Here are some additional points to keep in mind about derivatives and the treasury:
- Derivatives should be used as part of an overall risk management strategy. They should not be used as a substitute for sound risk management practices.
- Derivatives can be risky instruments and can lead to losses if they are not used properly.
- Derivatives should be used in accordance with the company’s risk appetite and financial objectives.
- Derivatives should be regularly monitored and reviewed to ensure that they are still effective in managing risk.
It is important to remember that derivatives are not a guarantee against loss. They simply provide a way to manage risk.