Advances in Economics, Business and Management Research, volume 203

Proceedings of the 2021 3rd International Conference on Economic Management and

Cultural Industry (ICEMCI 2021)

Financial Derivatives and Their Application in

Enterprises
Wanying Huang1, *, a, † Xinrun Yao2, b, †
1
School of Earth and Environment, University of Leeds, LS2 9JT, Leeds UK
2
School of Economics, University of Nottingham Ningbo China, 315000, Ningbo China
*
Corresponding author. Email: aee19w2h@leeds.ac.uk, bsayxy5@nottingham.edu.cn
†
These authors contributed equally.

ABSTRACT
With the opening of the financial market, the financial derivatives market has also encountered greater development
opportunities. However, opportunities and challenges always coexist, so enterprises must use financial derivatives
reasonably and correctly. This paper adopts the method of combining theoretical analysis with case analysis to
introduce the types, risks, applicable mechanisms and typical application cases of financial derivatives in detail. In
addition, through detailed descriptions of the theoretical underpinning, the reader could learn about the trading
processes and profitability mechanisms of several major derivatives, as well as conducting immersive simulations
through case studies. Through in-depth analysis and research, it is concluded that enterprises should actively invest in
technology and resource support, use derivatives to control risks and realize enterprise value. Hedging, rather than
random speculation, should be the first rule of thumb for companies using derivatives. It is hoped that the research of
this paper can provide a good way for existing enterprises to use derivatives to avoid risks and help the financial
derivatives market achieve steady development.

Keywords: Financial derivatives, Risks, Application, Hedging, Speculation arbitrage.

since 1851. Today, derivatives act as major positions in

1. INTRODUCTION
many exchanges worldwide and are used in capital
Derivatives markets have become increasingly investment projects and salary returns for executives.
important in finance over the past few decades. Futures, The purpose of this paper is to introduce some basic
Options trading are very active in many exchanges [1]. knowledge of derivative products, which is mainly
Derivatives trading is now the world's largest business, divided into four parts:
estimated at more than $2.5 trillion a day and growing at
about 14 per cent a year [2]. Nowadays, financial (1) What are the types of derivative instruments
institutions routinely trade derivatives on and off the Forward, future and option.
counter. Derivatives are incorporated into securities,
used in capital investment projects or as incentives and (2) Types of risks existing in the company
rewards for corporate executives. In the current market
environment, the knowledge of derivatives is a must for
(3) How to apply different tools to various risks
every financial practitioner [3]. First, forward foreign exchange contracts can solve
financing problems, help companies broaden financing
Derivatives date back to the commercial origin of
channels, and avoid capital turnover risks. Meanwhile,
Mesopotamia in 4000 BC and later survived in canon
through the futures contract to solve the price volatility
law in Western Europe. Renaissance derivatives became
risk of import and export products, avoid the company's
mature and applied widely around the world in the 17th
foreign exchange risk. Moreover, speculative profits can
century. In 1865, the Chicago Grain Exchange
be obtained through options to avoid market risks.
introduced a standardized agreement for the earliest
financial derivatives, "futures contracts", developed in
human history, replacing the forward contracts used

Copyright © 2021 The Authors. Published by Atlantis Press International B.V.

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(4) Enlightenment from the above analysis payment and settlement time are different, and the
participants are different. Forward contracts are
First, it is necessary to master the basic requirements
typically transactions between financial institutions in
and principles of using financial derivatives, face up to
the over-the-counter market. It is a contract to buy or
their high leverage and complexity. Secondly,
sell a product at a specified time in the future at an
companies need to attach importance to financial
agreed price [8].
derivatives from the strategic level and provide
sufficient technical and resource support. Finally, it is Futures contracts are made on an exchange. The
significant to understand that derivatives are used for underlying assets of futures trading include a variety of
hedging, not speculation. commodities and financial assets. Commodities include
pork, soup, wool, wood and so on. Financial assets
This article is divided into six parts. First, it gives an
include stock indexes, currencies. Financial media
overview of the history of derivatives and clarifies the
regularly publish futures prices, determined by the
four objectives of this article. Then it introduces the
supply and demand of assets [9].
basic knowledge of futures, options and forward
contracts in derivatives. The third part describes the Options are divided into American options and
company's several risks, divided into systematic risks European options. An American option means that the
and non-systematic risks. The fourth part explains the option holder has the option to exercise the option at
application of derivatives through several case studies. any time before the expiration date. European option
The last two parts are respectively optimistic prospects means that the option holder can only choose to exercise
for the future development of derivatives, and the the option at the expiration date. Unlike the forward
conclusion of the whole article, pointing out that we contracts, it does not require buying or selling the
should be a more cautious and better use of derivatives underlying asset, but it does require paying a fee to own
the option [9].
2. DERIVATIVE INSTRUMENTS If the spot price rises, then buying the call option
may be profitable. Once the price rises above the
A derivative is a product derived from a basic
exercise price and exceeds the number of paid royalties,
variable and can be traded on an exchange or
the deal becomes profitable.
over-the-counter market. The advantage of trading on an
exchange is that traders do not have to worry about the If the spot price falls, then buying the put option
creditworthiness of their counterparties. The clearing may make a profit. A trading profit is made once the
house solves this problem by requiring both traders to price falls below the exercise price by more than the
keep a certain margin at the clearing house to honor royalty paid.
their covenants [4].
However, the complex design of exchange-traded 3. TYPES OF RISKS EXISTING IN
contracts makes the valuation extremely complex, thus COMPANIES
making exchange-traded derivatives have high inherent
Systematic risks are caused by external factors,
risk [5]. OTC transactions can allow small companies to
which are the risk factors facing the whole financial
trade without being required to go public. They can also
market, such as the economic cycle and national
be used for hedging, transfer trading risk, and leverage
macroeconomic policies. These risks, also known as
for business operations [6]. However, the downside of
non-diversification of risk, cannot be offset by
OTC trading is that it is riskier relative to exchange
diversification.
trading because of the lack of clearinghouses and,
therefore, lack of transparency. Regulators do not know Unsystematic risk occurs within an industry or a
the exact nature and extent of the risk to increase the company, contrary to the systemic risk caused by
credit or default risk associated with each OTC contract. external factors. It is a diversifiable risk and can be
The speculative nature of the transactions resulted in a offset by diversified investments [10].
lack of integrity in the market [7].
Systematic risk includes interest rate and Exchange
There are three types of derivatives: forward risk, while unsystematic risk includes credit, financial,
contracts, futures and options. management, and liquidity risks.
Forward contracts are very similar to futures
contracts, the biggest difference being that forward 3.1. Systematic risks
contracts are not traded on an exchange and trade
standard fixed assets. In addition, the two contracts are 3.1.1. Interest risk
different in form. For forward contracts, the quality of
Interest rate risk refers to the possibility that the
commodities and the delivery date are all decided by
uncertainty of the market interest rate change causes
both parties without strict standards. The deposit
losses to enterprises [11]. Such risks often suffer

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because of the high sensitivity of corporate debt or 4. THE EFFECT OF FINANCIAL

investments. As interest rates rise, lenders will raise DERIVATIVES ON ENTERPRISES
credit card and loan rates, making it cheaper for
businesses to get the money needed. At the same time, 4.1. The origin of financial derivatives
the inability to repay the risk of the rate hike could
reduce bank lending. In the 1970s, after the collapse of the Bretton Woods
system, the fixed exchange rate system transformed into
Interest rate fluctuations may affect different
the floating exchange rate system. Frequent fluctuations
companies differently, but almost every company is
of the exchange rate and the wave of financial
affected by interest rate fluctuations. Generally, the
liberalization brought exchange rate risks and interest
impact of interest rate on a company depends on the
rate risks to countries. To meet the need for hedging in
choice of financing methods :(1) capital structure; (2) a
the financial market, financial derivatives have been
combination of fixed and floating rates; (3) A
developed to deal with the exchange rate and interest
combination of short-term and long-term debt [11].
rate problems [16]. Furthermore, the role of financial
derivatives is more diversified.
3.1.2. Exchange rate risk
Exchange rate fluctuations may bring companies 4.2. Hedging and speculation arbitrage
either opportunities or losses. The fluctuations in
Hedging is when an investor buys or sells the actual
foreign exchange rates may affect corporate costs and
goods on the spot market and sells or buys the same
profits, cash flow and market value, especially for those
number of futures contracts on the futures market.
with multinational, multi-currency businesses [12].
Under the domination of the supply and demand
relationship, the price trend of the spot and futures
3.2. Unsystematic risks markets is generally the same. However, since investors
operate in the opposite direction in two markets, they
3.2.1. Credit risk could avoid risks and reduce losses through hedging.
Credit risk stems from the possibility of default by Speculation and arbitrage refer to that investors take
counterparties of loans, which was also an important advantage of the price difference in different periods to
cause of the financial crisis in the early 2000s. Credit buy low and sell high. According to the interest rate,
risk, also known as default risk, refers to the possibility exchange rate or price risks that investors encountered,
that the borrower, the issuer of securities, or the other they profit by frequent buying and selling derivatives to
party of the contract violates or fails to perform the speculate.
contract terms, resulting in losses to investors or
counterparties. Otc derivatives and OTC derivatives 4.3. Function of financial derivatives
involve different credit risks because of different
settlement methods [13]. The good use of derivatives is beneficial for
companies to achieve more effective risk control,
3.2.2. Management risk reducing the risk of enterprises at the same time.
Moreover, idle funds can be effectively used for
Management risk refers to the deviation of enterprises and society, while risks can be controlled,
management level caused by information asymmetry, transaction efficiency can be improved, and resource
misjudgment and mismanagement in the management allocation ability can be optimized.
operation process. It can be divided into four parts: the
quality of managers, organizational structure, corporate 4.4. Cases study of financial derivatives
culture, management process. If the management
problems occur, irreparable losses will be caused to the Since the 2008 financial crisis, the world economy
enterprise and managers [14]. has been in a state of recovery. In recent years, with the
rise of global protectionism and the impact of
3.2.3. Liquidity risk COVID-19, corporate risk management has become an
important work. According to the research of
Liquidity risk includes asset liquidity risk and BARTRAM et al. [17] more than 60% of companies in
liability liquidity risk. The former is when an asset is the international financial market have used financial
not collected in time to meet subsequent debt payments. derivatives for risk management. The research of Zhang
Liability liquidity risk refers to the risk of loss caused Qian et al. [18] displays that more than 62% of listed
by the impact of external and internal factors [15]. companies in China use financial derivatives, and the
proportion has a significant upward trend. For China,
reasonable regulation of the use of financial derivatives
can promote the construction of the financial market and

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drive enterprises to effectively use financial derivatives will also affect purchasing from foreign markets, which
to solve their own difficulties. will directly affect copper prices and company profits.
In short, it will bring changes in raw material prices and
The high leverage of financial derivatives and
inconvenience to the company's production and
complexity, as well as its trading problems such as
operation activities.
nonstandard information opaque in the process of
operation, determines its while avoiding risk, and there In this regard, Jiangxi Copper's solution is to
is a huge risk, combined with China financial market establish a long position in the futures market, buy the
itself is not perfect, so most enterprise use derivatives to corresponding number of futures contracts in the futures
achieve the hedging function. Only a few larger exchange, and close the position after the expiration of
powerful capital, fault tolerance of high rate of the the contracts to reduce or avoid the risk of raw material
enterprise to realize the function of the speculative price fluctuations. But sometimes due to differences in
arbitrage through financial derivatives. Therefore, the the international environment, may make the futures
enterprise shall be an efficient use of derivatives and market, the price of raw materials at home and abroad
actively explore maximize the value of derivatives [19]. after the conversion, and even to the point of buying
Through the elaboration of financial derivatives value high and selling low Jiangxi copper, the solution is
effect on the company-specific case, this article tries to based on the total annual production and operation plan
help other companies provide a learning path and realize to determine the required raw materials, to use in the
the value of optimization. total amount divided by the number of futures contracts
agreed trading days, got a plan Then use the planned
4.4.1. The case of the Vanke group quantity minus the actual quantity of raw materials
delivered every day to get a difference, the difference is
Financing difficulty is a problem that most the Jiangxi copper industry needs to build futures
enterprises will encounter in the process of operation positions in the futures market that amount.
[20]. Still, Vanke group has solved this problem to a
certain extent by using forward foreign exchange In this way, Jiangxi Copper can not only avoid the
contracts. uncertainty caused by the exchange rate risk of
international procurement, but also balance the
Vanke Group, using its own foreign debt quota to purchasing quantity of raw materials, reduce the related
foreign banking institutions to apply for a loan, at the risks caused by the price fluctuation of raw materials,
same time entrust domestic bank financing guarantee and make preparations for the company's production
institutions do Foreign Banks to Vanke group set up the and operation.
special account for external debt in the lending, at the
same time, the same period Vanke and signed with 4.4.3. The case of Roche Holdings
banking institutions within the territory of the deadline
of forwarding foreign exchange contracts, and In 1991, Roche holding common 10-year dollar
determine the amount of the purchase of foreign could have 8.65% according to borrow, used for
exchange in the future Vanke can use overseas loans to business investment But to reduce the cost of financing,
make an investment or fund allocation in China, buy Roche holding hybrid securities issuance of $1 billion,
foreign exchange according to the agreed amount and is a bull market spreads debt this mixed by a 10-year
forward exchange rate when the contract expires, and bond (annual interest rate of 3.5%) and a group of
repay the cash to the overseas bank. three-year option certificate. Warrants give the investor
a put option at a low price (sFr70 or less); when the
Through forward foreign exchange contracts, Vanke
share price is higher (more than 100 Swiss francs) to the
borrows foreign funds for domestic investment, which,
issuer when call options, investors have the highest
on the one hand, solves the situation of domestic
returns. Three years later, the company's share price
financing difficulties, expands financing channels for
rose to 125 Swiss francs, company to exercise warrants,
enterprises and increases the domestic capital flow. On
from investors bought authority cards, for investors to
the other hand, forward foreign exchange contracts can
maximize returns. In addition, Roche holdings by 3.5%
lock in borrowing costs, carry out risk control and hedge
annual interest rate of financing reduce the financing
funds for enterprises.
cost.
4.4.2. The case of Jiangxi Copper The bull market spread warrants of Roche Holding
not only reduce the financing cost for the company but
Jiangxi Copper is one of the largest production bases also help the company to obtain profits, harvest the
of copper products in China. Due to its great demand for funds needed for acquisition, but also maximize the
raw materials, it needs to purchase a large number of interests of investors and realize the value of financial
copper products in domestic and foreign markets to derivatives, which has played a significant role in the
meet production requirements. Foreign exchange risks development of the company [21].

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5. INSPIRATION AND PROSPECT derivatives risk aversion. Not only in theory based on
the detailed description, make readers aware of several
Through the good use of financial derivatives, to a main derivatives trading processes and mechanism of
certain extent, can bring positive benefits for the profit. In addition, through specific case analysis, it
company. provides examples for companies to refer to and learn
First of all, from the perspective of the internal about the application of derivatives, to enhance the
effect of enterprises, the company, through the financial value effect of derivatives on companies.
hedge risk control, to improve enterprise value and the Through systematic analysis, the main conclusions
optimization of resource allocation structure, can from of this paper are as follows: First, even if there are
the enterprise internal organization structure, reduce different opinions about the utility of derivatives,
costs further and increase revenue [22]. unreasonable use will indeed bring great risks, but
Secondly, from the perspective of external effects of compared with the risks existing in the company,
enterprises, if all enterprises can skillfully use financial derivatives can still play a positive role in risk control.
derivatives to reduce interest rate risk, exchange rate Second, reasonable use of derivatives is conducive to
risk and market risk, it can significantly reduce the the value of the company promoted, boost overall
overall volatility risk of social and economic activities efficiency, and even benefit the upgrade of industrial
and enhance the stability of social and financial order. structure and resource allocation optimization. Third,
However, the problems existing in the application of many cases illustrate the use of derivatives need to
financial derivatives cannot be ignored. The use cost of match the qualified technical support, resources support
derivatives is high. Small enterprises do not have the and financial support, etc., do not have sufficient
ability and resources to use them, and enterprises with conditions for the company should be careful to use
insufficient strength may suffer losses due to derivatives. Fourthly, the primary function of
insufficient investment. In addition, if the return of derivatives should be hedging to carry out reasonable
using derivatives for hedging is even less than that of risk avoidance to minimize losses and increase returns.
ordinary risk management, enterprises will abandon it Any derivatives transaction with risk exposure should
because of higher costs [23]. Therefore, to promote the be carefully considered or directly abandoned.
prosperity and development of China derivatives The limitation of this article is mainly manifested in
market, these important problems must be solved. not enough in-depth research and analysis, failed to
Although China financial derivatives market started deeply analyze the derivatives of theoretical and
late, and it exists some deficiencies. Still, with the practical. It is hoped that through in-depth research and
development of financial liberalization and economic thinking, the general applicability of derivatives can be
integration, more and more enterprises trust the mastered in the future. The practicality of derivatives
derivatives business. It can be foreseen that China can be implemented to the maximum so that companies
financial derivatives market will be further opened in with various sizes and financial strength and technical
the future, and more enterprises will be attracted to enter strength can control their risks through financial
the derivatives market through institutional and policy derivatives. At the same time, the risk of derivatives
reforms, such as lowering the hedging threshold and itself will be reduced, and the stability of the derivatives
increasing fiscal and tax support for enterprises [24]. In market and social economy will be enhanced because
addition, under the theme of deregulation and the value of financial instruments can only be realized
regulation, while opening the market, the government when they really play a role at the company level.
will also strengthen the supervision of the trading
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