- 4 - Derivatives – The Next Big Thing for B2B? Shoomon Perry, March 2001 © 2001 Sixhills Consulting Ltd & Author Endnote - Derivatives Demystified Companies use derivatives either to hedge price risk or speculate. Hedging behaviour can be simplified into two scenarios:  Supplier hedging: Costs are incurred at start of production process, sales made at the end. Suppliers want to hedge the risk that the product’s price drops over this period  Purchasers hedging: If a producer anticipates demand for commodity 3 months from now, it may want to hedge the risk that the price rises dramatically in the mean time. Derivatives are not the only way to hedge these types of risk. Long-term contracts can be used to lock in price and terms to both supplier and purchaser (e.g., steel) Three preconditions have to exist for a new derivative product to take off:  Sufficient commoditisation: Product standardisation allows derivative contract terms to be specified, and is usually associated with many buyers and many sellers in the marketplace  Sufficient price volatility: If the price doesn’t fluctuate, it doesn’t present a risk that needs to be managed.  Sufficient market size: Industry hedgers have to be sufficiently exposed to the cost of the product to warrant hedging its associated price risk Derivatives can either be bilateral agreements between two parties (“Over The Counter” contracts) or exchange-traded contracts. An example of an OTC contract would be Enron agreeing with an oil tanker operator to take on the risk that price of shipping oil across the North Sea drops in the next 6 months. An example of an exchange traded contract is the LIFFE Robusta coffee contract: manufacturers and producers trade the right to buy/sell a standard lot of Robusta coffee for delivery at any one of 12 warehouses worldwide at a particular date. Finally, derivatives can be split into physically settled and cash settled products. Physically settled contracts allow for the physical delivery of the underlying commodity to the counterparty: cash settled contracts are based on the movements of a representative price index (e.g. the Baltic Exchange shipping indices). Shoomon Perry, March 2001
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