As a financial tool, derivatives play an increasingly important role in the financial situation of large global companies. Their importance is mainly reflected in the great development of derivative trading markets in the most developed countries, and banks are usually the trading centers of these powerful financial instruments. The essence of their importance is that companies can use them to reduce the uncertainty or risk brought by entrepreneurial activities. Financial managers use derivatives to understand the risks their companies face every day, so that they can pursue higher returns, because higher returns bring higher risks. The management of high risks enables companies to reduce the risk of financial losses and get higher returns at the same time. The extensive use of derivative products can also bring further benefits to the company's financial situation by improving several other corporate behaviors, such as reducing borrowing costs, tax planning and ensuring safer loan repayment. However, derivatives trading has become a reason for the huge losses of many companies, and the financial management of these companies ignores the high risks involved in using these financial instruments. This paper will try to examine the ways in which companies use derivatives to improve their financial situation.

Derivative instrument (or derivative securities) can be defined as a tradable asset, and its intrinsic value depends on or comes from the value of basic assets (such as stocks or bonds), commodities (such as oil or gold) or abstract indicators (such as interest rates or indexes). This dependence on the value of derivatives is the reason why they are also called contingent claims. The last definition of derivative products accurately describes their nature as exercisable rights or obligations rather than tradable goods. This kind of right or obligation is an exact legal contract that obtains value like physical assets, so it can be traded. Since ancient times, people have implemented derivatives as legal contracts, although their systematic use and trading began in the late 19th century. However, the past three decades have witnessed a huge increase in the trading volume of derivatives. Nowadays, the derivatives market plays an important role in the world financial transaction system, and its types and uses are constantly developing to meet the different financial needs of different industries. Common types of derivatives are options, futures, forwards, forward interest rate agreements and swaps, while other less common types are upper limit, lower limit, exotic options, OTC and exchange-traded derivatives. The most common derivatives are briefly described below.

Option is a kind of contract agreement, which gives one party the right to buy or sell basic goods or assets at a given price within a predetermined time, but not the obligation. At the end of the pre-specified period, according to the needs of the option holder, this right can be exercised or not, so the name of the derivative product is derived. If an option gives the buyer the right to buy an asset (such as some stocks) for a given period of time, this option is called a call option. At the end of the term, the right expires, and after that date, the option loses its value. On the contrary, if a similar contract gives the buyer the right to sell an asset (at an agreed price and a given date), it is called a put option. Call and put options enable their holders to make profits and reduce the uncertainty of the future value of the underlying assets, because they can be traded at any time before the maturity date. If the underlying asset is a stock index like FTSE 100, Standard & Poor's 500. 500 pence, etc. Then the right to buy is called index option.

Futures is also a contractual agreement between two parties to buy or sell assets at a specific time and at a predetermined price. However, futures represent obligations, not rights, in specific transactions, so once an agreement is reached (or futures are purchased), neither party can go back on its word. Therefore, the futures holder buys the debt of the other party, not the right, just like the option. However, futures are tradable derivatives, which are traded in a regulated market like options. This feature allows its holder to change its position according to the change of the underlying asset value with time before the contract transaction date. However, they are very standardized, so they may not be very attractive to companies with specific financial needs. Futures based on the short-term interest rate of foreign bank money deposits are called interest rate futures.

On the other hand, forwards are agreements similar to futures. In this sense, they all represent the obligations of both parties to the contract to trade at an agreed price on a specific date. However, forward contracts are not standardized contracts that can be traded on exchanges, but agreements tailored for specific customers, which can usually be traded over the counter (for example, between banks and buyers). Foreign exchange is one of the most important basic assets in forward trading, which provides a special trading market for currency. The floating interest rates of different currencies bring uncertainty to the repayment of floating interest rate loans in the future. For this reason, banks and companies can sign a forward interest rate agreement (fra) to ensure that if the floating interest rate related to loan repayment exceeds a predetermined amount, they will get a premium from the bank. Fra is also tradable, usually short-term contracts ranging from 3 months, 6 months or 12 months.

The exact way of loan repayment related to floating interest rates has created the demand for swaps. Swap is a private contract between companies to exchange bank interest payment obligations. Under the swap agreement, the company may be able to jointly design a cheaper repayment plan for both parties. Unlike fra, swaps usually require a longer negotiation period and can be signed and traded in a similar way to options.

From the above description of the most common derivatives, it is obvious that companies have a powerful toolbox of financial tools that can be used to improve their financial situation. Their main purpose is to reduce the uncertainty of the future value of assets or commodities. This practice is called risk hedging. Hedging can be done with options. For example, if a pharmaceutical company announces that they may cure cancer within six months, the stock price will soar, but the financial manager may worry that this announcement cannot be realized. They can protect the company's financial situation through Ying Bu put options, which can be exercised if the company fails to find a cure for cancer (so its stock will hit rock bottom).

This option issued by the company itself is called a warrant. Option or warrant hedging can be used to deal with multiple potential declines in stock prices or the whole market. Therefore, hedging helps to protect companies from financial turmoil.

Options can also be used in the incentive payment plan from the company to employees, and employees can get call options, which can be exercised when the company's shares are higher in the future. This proposal encourages employees to increase their share by improving their work performance. Therefore, the company has improved productivity through this indirect payment method.

Another potentially beneficial use of options is tax planning. Large multinational companies can take advantage of the differences in tax legislation in different countries where they operate and reduce the total tax payable or capital cost by trading options in different jurisdictions. Tax practitioners can design options trading methods to achieve tax reduction without significantly changing the company's financial situation.

Hedging can also occur in the futures of basic commodities. Many major producers are uncertain about the future prices of goods that are vital to their business, so they use futures to ensure that their production costs are not affected by price increases. Therefore, they are willing to pay a premium to ensure that they are not affected by price fluctuations. According to the same principle, large investors with large and diversified portfolios may want to hedge with stock index futures, which are very sensitive to the overall trend of stock indexes. In this way, if the index plummets, they can reduce their losses.

All derivatives related to interest rate payment can also be used to hedge the risks brought by floating interest rates. Fras are particularly useful in this case because they assure the holders that interest rates will not fall. Use slightly different interest rate hedging techniques in the upper and lower limits. These hedging techniques are particularly useful for companies that need to eliminate or reduce the risk of short-term fluctuations in interest rates, so they are willing to pay a risk premium.

Risks associated with exchange rate fluctuations can also be hedged by using derivatives. Domestic economic transactions are priced according to the relative exchange rates of the currencies involved. For example, the euro value of an export commodity priced at one pound in Britain is unstable. This means that the same transaction can have different values, depending on the currency exchange rate. Multinational companies and enterprises directly related to foreign trade (import/export) are extremely sensitive to fluctuating exchange rates, so they hope to use derivatives to reduce this uncertainty. Futures can be used to ensure future currency transactions, regardless of future exchange rates. Or when companies need more flexibility, they can use currency forwards that are not as standardized as futures, or they can customize them separately. Alternatively, enterprises can use currency options, which can not only hedge foreign exchange risks, but also make extra profits when the exchange rate is favorable.

In a word, derivative securities improve the ability of financial managers to improve the company's financial situation and reduce the uncertainty of the future of enterprises and financial markets. Nowadays, the importance of derivative products can be observed by the explosive development of derivative trading markets in developed economies all over the world. Derivative instrument is a kind of contract agreement, which represents the rights or obligations of the contractor to conduct pre-specified transactions in the future, and can take different forms and changes according to the specific needs of the business. However, their most common function is to reduce the risks in future economic transactions, so that enterprises or institutions can better resist economic uncertainty, which has obviously brought huge costs to entrepreneurial activities in the past. This change in the risk status of enterprise activities, also known as hedging, sometimes helps to obtain huge profits at the same time, thus giving derivatives greater importance. In addition, derivatives can prove beneficial to companies when used in incentive payment plans, tax planning or loan repayment. With the increasing use of derivatives in the past 30 years, it is certain that they will be more widely used in enterprises through the design and implementation of new derivatives.

refer to

Arnold, G. (2005), Corporate Finance Manual, Financial Times prentiss Hall.

Eales, B., a .( 1995), Financial Risk Management, McGraw Hill: Maidenhead.

Hull, J., c .(2000), Option Futures and Other Derivatives, (5th Edition. ), prentiss Hall International Company.

Taylor, f .(2000), Mastering the Derivatives Market, (2nd Edition). ), Financial Times prentiss Hall

(1995), Financial Derivatives, Chapman and Hall: London.

Can't send it anymore. I'm uploading it to the mailbox. . .