This lesson provides a detailed examination of the derivative instruments used in risk management, with a focus on their strategic application .

5.1. The Mechanics and Uses of Derivatives

Derivatives are financial contracts whose value is derived from an underlying asset, index, or reference rate . They are used for :

• Hedging: Reducing or eliminating an existing financial risk. This is the primary treasury function.

• Speculation: Taking on risk in the hope of making a profit. This is generally not a treasury function.

• Arbitrage: Exploiting price differences in different markets to make a risk-free profit.

5.2. Hedging vs. Speculation

A fundamental principle of treasury risk management is the distinction between hedging and speculation . Hedging is about protecting the organisation from financial loss. Speculation is about taking on risk for potential gain. Treasury policy should clearly distinguish between these activities.

5.3. Case Study: Selecting a Hedging Strategy

The ACT practice paper  provides a scenario to compare forward contracts and money market hedges. For a six-month €500,000 receipt, a treasurer would evaluate the dollar value using the forward rate and a money market hedge calculation. This case demonstrates the practical application of these techniques to optimise the financial outcome.