Derivatives and Hedging

Abstract

This note is a valuable read in any finance or accounting course that is covering the risks of derivative securities. In October 2011, MF Global Holdings LTD, a New York City brokerage company, filed for bankruptcy. Almost a billion dollars was missing from customer accounts that were supposed to be segregated from MF Global's trading accounts. Thousands of U.S. farmers collectively lost millions in their trading accounts at MF Global. This note explains the risks many businesses face including unknowable future material prices, interest rates, and currency exchange rates and how derivative securities are often used to hedge or protect against these risks. Excerpt UVA-C-2341 Jan. 29, 2013 Derivatives and Hedging On October 31, 2011, MF Global Holdings LTD, a New York City brokerage company, filed for bankruptcy—the eighth-largest U.S. filing at that time. Almost a billion dollars was missing from customer accounts that were supposed to be segregated from MF Global's trading accounts. Thousands of U.S. farmers collectively lost millions in their trading accounts at MF Global. Shortly after the bankruptcy filing, a National Public Radio reporter visited a farmer who had lost his money in an MF Global account and asked “Why are you speculating in cattle prices and why are you taking on that risk?” The farmer responded: Hedging is not speculation—it's how I avoid speculation. Farming without hedging is speculation; you invest in your crop or your cattle without knowing what you'll be able to sell it for. Hedging takes a good deal of the risk out of our business. Businesses face many risks including unknowable future material prices, interest rates, and currency exchange rates. Derivative securities are often used to hedge or protect against these risks. Some of the most common derivative securities are forwards, futures, swaps, and options. . . .