The use of Derivatives markets and products by a company Essay

The use of Derivatives markets and products by a company - Essay Example Derivatives serve as ideal substitutes for complex investment strategies at a minimal cost. (Haugh and Lo 2001) Firms using derivatives have lesser risk exposure than which do not use.(Hentschel and Kothari, 2001) The banks who have used interest rate derivatives have shown higher growth in lending than those banks who do not use derivatives. (Brewer, Minton, and Moser 2000) From Micro-economic point of view, derivatives in different forms have the following functions. Swaps: These are mostly OTC contracts having longer period than options and futures and serve the purpose of meeting needs single client of a Bank or any institution. They afford firms to have new investment opportunities to hedge against any risks in currency rates, interest rates, and credit default etc. It is the periodical payments that represent the risks undertaken by these contracts and not their notional value. Futures: These are capable of increasing market efficiency and liquidity. Depending on national and international laws, this type of derivatives display very high transparency and are used to hedge and speculate in financial and commodity segments. Options: These are similar to futures but do not reflect clearly the underlying assets and do not give unique empirical results unlike options. The notional value does not represent the risk undertaken but the premium paid for opening and closing signify the extent of investment. Repos: These are unique to inter-banking transactions between RCB and European inter-bank system and are meant for finance liquidity rather than to hedge or speculate. The use of derivatives by a company is proposed to be demonstrated in this paper by the example of Glaxo Smithkline (GSK), world's one of the largest pharmaceutical giants. GSK uses derivatives among various finance instruments to finance its operations and manage market risks. The company's derivatives are mainly foreign currency contracts, interest rates and currency swaps. It uses them for swapping of its borrowings and liquid assets into currencies needed for the entire group of the plc. It uses derivatives to guard against changes in foreign exchange currency rates and interest rates. The derivatives are not used for speculation but only used to hedge against its own risks stemming from targeted business operations. It neither issues nor holds derivative financial instruments for trading purposes as a company policy. They are initially shown at cost in the Balance Sheet and revalued subsequently on the relevant reporting dates at fair value. The ones that are treated as hedges are designated as fair value hedges, cash flow hedges or net investment hedges. Changes in fair value of derivatives designated as fair value hedges are shown in the income s tatement with corresponding entries in the hedged asset or liability. Those designated as cash flow hedges are reflected in equity to the extent they are effective. The remaining portion that is not effective is reflected in profit and loss account at the same time. Those deferred in equity are later taken to income statement when the hedged asset results in