Pros and Cons of Financial Derivatives

Globalization has made it difficult for small businesses to survive in the competitive environment. In addition to competing with large companies, they need to face economic fluctuations.

Therefore, small companies are forced to take up any opportunity that is available to increase profits. One such option is available in the form of financial derivatives. These instruments derive their value from an underlying asset, such as commodities, currencies, indices, shares, or others.

There are four types of such financial instruments. These are swaps, forwards, and futures and options (F&O). These contracts are either negotiated between parties or traded on the financial markets. Futures and forward contracts give the buyer and seller to purchase or sell the specified underlying asset at an agreed price on or before the date of expiry. Options contract give the buyer the option with no obligation to purchase the underlying asset. Swaps contracts have the rights

 

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and obligations to exchange one form of underlying for another.

Having understood different types, below are their pros and cons.

Pros of financial derivatives

  1. Predict future prices

Small companies are able to predict future prices of raw materials based on the price of the F&O contracts. This enables them to make informed purchase decisions and avoid unnecessary expenses towards raw materials costs.

  1. Stabilize purchase expenses

Businesses may enter into forward contracts for their raw material requirements. This enables the companies to lock their purchase costs. In case, the price increases, they are able to buy materials at a lower expense. Alternatively, if price decreases, companies may allow the contract to expire.

  1. Hedge currency rate fluctuations

If businesses purchase raw materials in foreign currency, they may reduce the exchange rate fluctuations through these financial instruments.

  1. Maximize profits

Companies are able to lock-in raw materials purchase prices and hedge their risks against foreign currency fluctuations with financial derivatives. This enables them to maximize their profits because they are able to sell their products at fixed prices in the domestic markets.

Cons of financial derivatives

  1. Potential losses

In case, small companies are unable to use such financial instruments accurately, it may result in huge potential losses. Sometimes, it may result in bankruptcy.

  1. Financial distress

In the event that business owners are unable to predict the price movement accurately, the prices of raw materials may increase thereby enhancing their purchase costs. This may cause financial distress and liquidity issues for small companies.

  1. Higher funding costs

When a company gets into an interest-related contract, the funding cost limit is pre-determined. In case the interest rates descend, the funding cost rises, which may result in financial trouble for the companies.

Certain contracts like forwards and futures are beneficial. However, when used incorrectly it may cause financial difficulties. It is important that companies analyze pros and cons to make the right decisions on how to best use these financial instruments for maximum benefits.