Business Finance · Financial instruments issued or used by companies

Derivatives Used by Companies to Hedge Risk

Updated 11 October 2026 · Fact-checked

A derivative is a contract whose value depends on an underlying asset, rate or price. Companies use forwards, futures, options and swaps to fix or limit their exposure to interest rates, exchange rates and commodity prices. In exams, identify the exposure, pick the instrument, work out the outcome and state the trade-offs.

Understand Derivatives Used by Companies

A derivative is a financial contract whose value comes from something else: an interest rate, a currency, a commodity price or a share price. The company does not need to own the underlying asset. It uses the contract to change its exposure to price movements.

Companies mainly use derivatives to hedge. Hedging means reducing a risk that already exists. An exporter expecting dollars in three months loses if the rupee strengthens. A borrower on a floating-rate loan loses if rates rise. A manufacturer buying metal loses if prices rise. A derivative can offset each of these.

The four main instruments differ in how they work:

Forward: a private (over-the-counter) agreement to buy or sell an asset at a fixed price on a future date. It can be tailored to the exact amount and date. It carries counterparty (credit) risk.
Future: a standardised forward traded on an exchange. It has fixed contract sizes and dates, daily marking to market and margin. A clearing house reduces credit risk. Hedges are rarely a perfect match.
Option: gives the holder the right, but not the obligation, to buy (call) or sell (put) at a set strike price. The buyer pays a premium and keeps the benefit of favourable moves. The seller takes the obligation.
Swap: an agreement to exchange cash flows over several periods. In an interest rate swap, one party pays fixed and receives floating, or the reverse, on a notional amount. The notional is usually not exchanged. A currency swap exchanges payments in two currencies.

The key trade-off is this. Forwards, futures and swaps lock in a price. They remove the downside but also the upside. Options keep the upside but cost a premium up front. Using derivatives to speculate, rather than hedge, adds risk. Companies also face basis risk (the hedge does not move exactly with the exposure), counterparty risk, and accounting and governance issues.

Key rules to remember

Forward price (no income, continuous compounding): F = S₀ × e^(rT); S₀ is the spot price, r the risk-free rate and T the time in years. Assumes no storage costs, no income and no arbitrage. With annual compounding use F = S₀ × (1 + r)^T.
Forward price with known income: F = (S₀ − PV of income) × e^(rT); Use for assets paying known income, such as dividends or coupons, during the contract.
Interest rate parity (forward exchange rate): F = S × (1 + i_quote) ÷ (1 + i_base); Rates are for the same period. S and F are units of quote currency per one unit of base currency. For INR per USD, i_quote is the rupee rate and i_base is the dollar rate.
Payoff of a long call: max(S_T − K, 0) − premium; Profit to the buyer at expiry. S_T is the price at expiry and K is the strike.
Payoff of a long put: max(K − S_T, 0) − premium; Profit to the buyer at expiry. Used to protect against a fall in price.
Net payment on a plain vanilla swap (fixed payer): Net = (floating rate − fixed rate) × notional × period fraction; Positive means the fixed payer receives. Negative means the fixed payer pays. Only the net amount is normally exchanged.
Effective cost of swapped borrowing: Loan floating rate + swap fixed rate − swap floating rate received; For a floating-rate borrower who pays fixed on a swap. If the swap floating leg matches the loan, the cost is the fixed rate (plus any loan margin).

How to solve Derivatives Used by Companies questions

Use this method for any question on how a company hedges with derivatives.

1Identify the exposure. State whether the company gains or loses when the rate or price rises, and over what period.
2State the objective: fix a price (certainty), or protect the downside and keep the upside.
3Choose the instrument. Use a forward or swap to fix, a future for a standardised exchange-traded hedge, and an option if the company wants to keep favourable moves.
4Set the contract terms: buy or sell, amount, date, strike or fixed rate, and premium if any.
5Calculate the outcome under each relevant scenario at expiry. Include the hedge result and the underlying exposure together.
6Compare with doing nothing and with the alternatives. Note the cost, flexibility and what upside is given up.
7State the residual risks: basis risk, counterparty risk, margin calls and liquidity, mismatch of amounts or dates, and speculative use.
8Give a clear conclusion that matches the company's objective.

Quickest way: Exposure, instrument, outcome

When to use it: Use in multiple-choice questions and short written parts where you must pick or evaluate a hedge quickly.

Ask: who loses if the price goes up, and who loses if it goes down?
If the risk is a rise in cost or rate, the company needs to buy the forward, buy a call, or pay fixed on a swap.
If the risk is a fall in income or asset value, the company needs to sell the forward, buy a put, or receive fixed.
If the answer says the company wants to keep the benefit of favourable moves, choose an option.
If the answer says certainty or an exact date and amount, think forward or swap. If it says exchange-traded or margin, think future.
Check the arithmetic for the chosen scenario, then add one line on a cost or risk.

Common mistakes in Derivatives Used by Companies

Choosing the wrong side of the hedge, for example selling a forward when the company needs to buy.
Students match the instrument to the market view instead of the existing exposure.
Fix: Write the exposure first: long or short the underlying. The hedge is the opposite position.
Saying forwards and futures are the same.
Both fix a future price, so the differences are skipped.
Fix: Remember: forwards are OTC, tailored and carry credit risk. Futures are exchange-traded, standardised, margined daily and cleared.
Ignoring the option premium when comparing outcomes.
Students look only at the payoff at expiry.
Fix: Always subtract the premium from the payoff, and compare the net result against the forward or unhedged result.
Thinking a swap exchanges the full notional amount.
Confusion with loans or currency swaps.
Fix: In an interest rate swap the notional is a reference amount. Only the net interest difference is paid, and the two parties' loans stay separate.
Claiming a hedge removes all risk.
Textbook examples assume a perfect match.
Fix: Mention basis risk, counterparty risk, margin calls and mismatches. A hedge reduces risk but rarely eliminates it.
Mixing up the rate currency in the interest rate parity formula.
Quote and base currency are not labelled.
Fix: Label the rate quote as quote currency per one unit of base currency. The currency in the numerator of the quote gets its interest rate in the numerator.

Worked examples

Example 1

An Indian company will pay US$2,00,000 to a supplier in 6 months. Spot is ₹83.00 per US$. The 6-month rupee interest rate is 3.0% and the 6-month dollar interest rate is 1.0% (both for the six-month period, not annualised). (a) Find the 6-month forward rate by interest rate parity. (b) Find the rupee cost if the company hedges with a forward. (c) If spot in 6 months is ₹85.00, find the saving from hedging versus not hedging.

Show the solution

The company must buy dollars, so it fears the rupee weakening. A forward purchase of dollars fixes the rate.
(a) F = 83.00 × (1.03) ÷ (1.01).
83.00 × 1.03 = 85.49.
85.49 ÷ 1.01 = 84.6436 (to 4 decimal places), so about ₹84.64 per US$.
(b) Cost = 2,00,000 × 84.6436 = ₹1,69,28,713 (rounded to the nearest rupee, using the unrounded forward rate 84.64356).
(c) Unhedged cost at ₹85.00 = 2,00,000 × 85 = ₹1,70,00,000.
Saving = 1,70,00,000 − 1,69,28,713 = ₹71,287.

Answer: Forward rate ≈ ₹84.64 per US$. Hedged cost ≈ ₹1,69,28,713. If spot is ₹85.00, hedging saves about ₹71,287. If the rupee had strengthened, the company would have lost the chance to pay less.

Example 2

A company has a ₹50,00,000 floating-rate loan at MIBOR + 1.5%. It enters a swap on a notional of ₹50,00,000 where it pays fixed 7.0% and receives MIBOR. In one year MIBOR averages 8.2%. Find (a) the net swap payment received or paid, and (b) the company's total effective interest cost for the year.

Show the solution

Loan interest paid = (8.2% + 1.5%) × 50,00,000 = 9.7% × 50,00,000 = ₹4,85,000.
Swap: company receives MIBOR 8.2% and pays fixed 7.0%.
(a) Net = (8.2% − 7.0%) × 50,00,000 = 1.2% × 50,00,000 = ₹60,000 received.
(b) Total cost = loan interest − net swap receipt = 4,85,000 − 60,000 = ₹4,25,000.
Check by rate: fixed 7.0% + margin 1.5% = 8.5%. 8.5% × 50,00,000 = ₹4,25,000. This matches.

Answer: The company receives a net ₹60,000 on the swap. Its effective interest cost is ₹4,25,000, which is 8.5% (fixed 7.0% plus the 1.5% margin). The cost is fixed regardless of MIBOR, assuming the swap floating leg matches the loan.

Exam tips

Start every written answer by naming the exposure and the hedge direction. Marks are often given for this alone.
Show the scenario table: outcome with the hedge and without, at two or three prices. Examiners like the comparison.
For interest rate parity and forward pricing, label the units of each rate and check that the period matches the rate.
Always add the downside of the chosen instrument, such as premium cost, lost upside, margin calls or counterparty risk.
In multiple-choice questions, check the direction of the payoff before calculating. Many wrong options use the opposite side.

Practice questions from Financial instruments issued or used by companies

Derivatives Used by Companies: frequently asked questions

What is the difference between forwards and futures?

A forward is a private, tailored contract settled at maturity, with credit risk between the two parties. A future is standardised and traded on an exchange, with daily margining and a clearing house. Futures are easier to exit but may not match the exposure exactly.

Why would a company use an option instead of a forward?

An option protects against an adverse move while allowing the company to gain from a favourable one. The cost is the premium paid at the start. A forward costs nothing upfront but removes any upside.

How does an interest rate swap help a company?

It lets a company change floating-rate payments into fixed, or fixed into floating, without repaying the original loan. The two parties exchange only the net interest difference on an agreed notional. This gives certainty of cost or exposure to the rates the company prefers.

Can derivatives increase a company's risk?

Yes, if they are used to speculate or are not matched to a real exposure. Margin calls can also strain cash flow. Good governance includes clear limits, approval and reporting of derivative positions.