Kenneth R. Szulczyk
Derivatives can protect investors from interest rate risks. Interest-rate risk is a bank borrows
funds for a greater interest rate than the bank earns on its loan. Remember, banks lend money
for a greater interest rate than the funds they borrow, earning profits. Unfortunately, the interest-
rate risk could reverse this, imposing losses on a bank.
Example 2: You manage a money-market mutual fund and it is June 2012. A money-
market fund is a fund filled with financial securities with maturities of a year or less. Moreover,
you expect an inflow of $1 million in funds in June 2013. You can buy a futures contract today
that earns a 10% return for your funds in June 2013, and you begin earning interest after June
2013. If the interest rate falls, the derivatives contract guarantees you a 10% return, protecting
your fund. A futures contract could be for Certificates of Deposit (CDs). A CD is customer
deposits money into a bank account for a fixed time period and is similar to a savings account. If
customers close and withdraw their CDs before maturity, then they forfeit the CDs interest.
Many countries call CDs as time deposits.
On the other side of the CD derivative, a bank grants a loan for $1 million to a customer
next year. Bank would transfer the funds in June 2013 at 12% interest rate. Bank could issue a
Certificate of Deposit on the futures market at 10%. Subsequently, the bank has guaranteed a
funding source next year for this loan. If interest rates rise next year, then the futures contract
protects the bank from interest-rate risk because the bank “locked” into a funding source at 10%
that ensures a profit of 2%.
Futures and forward contracts can reduce exchange rate risk. If a corporation operates in a
foreign country, that corporation can use derivatives contracts to protect itself from currency
exchange rate fluctuations.
Example 3: Exxon is a U.S. corporation that uses U.S. dollars to purchase petroleum from
Malaysia. Consequently, Exxon needs Malaysian ringgits and enters into a futures contract
because Exxon must pay 3,000,000 ringgits in 90 days. A Malaysian bank issued a derivatives
contract that specifies the exchange rate as $1 = 3 ringgits.
Exchange rates between countries fluctuate continually. Who pays the margin if the
exchange rate changes to $1 = 4 ringgits? The U.S. dollar appreciated while the ringgit
depreciated. Unfortunately, Exxon has U.S. dollars, and it contracted to pay a lower exchange
rate. Thus, Exxon must deposit money into the margin account because Exxon “locked” into a
depreciating contract. On the other side of the contract, the bank benefits from this contract.
Easy way to determine whom benefits is to convert the ringgits into U.S. dollars for both
the spot and futures market. We computed the spot transaction in Equation 1 and the futures
contract in Equation 2.
Spot market: 750,000
41
3,000 000 =$
rm$
, rm (1)Futures market: 1 , 000 , 000
31
3,000,000 =$
rm$
rm (2)