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Judging from all the bad press that derivatives have gotten over the past two years, you'd think they were the worst thing to be unleashed upon the world since Pandora decided that one little peek inside that pretty little box she was told to never open wouldn't really hurt anyone. But if you think derivatives are solely "financial weapons of mass destruction," as Warren Buffett once put it, then you're only seeing half of the story.
Speculation vs. Hedging
It's true that derivatives give investors great power to speculate. Want to bet on a continuing rise in the price of gold or silver? Futures contracts let you control thousands of dollars' worth of precious metals while only having to put up a small fraction of its value in cash. Think a hot tech stock is going to post outlandish earnings next week? Buy a call option for just a couple bucks, and if things go right, you could have a 10-bagger before you know it.
In some cases, you have speculators on both sides of a derivatives transaction. But there's a much different reason why some people use derivatives: to hedge business risks that they have. Without derivatives, many people's lives would be a whole lot harder.
Farming and finance
The Wall Street Journal highlighted one such use earlier this week, telling how farmers hedge some of their exposure to moving prices for their crops by locking in prices by using futures contracts. Although the article focuses on the impact of financial reform on farmers' hedging practices -- and gets it wrong, according to some critics -- the article's description of how hedging works is valid.
In fact, with agricultural commodities, derivatives actually make life easier both for farmers and for food companies that need those crops. In 2008, when commodities prices were soaring, hedging strategies helped Hershey (NYSE: HSY ) control and predict its expenses. General Mills (NYSE: GIS ) and Kraft Foods (NYSE: KFT ) routinely use derivatives to smooth costs of the raw materials they need to produce their products.
Other valid purposes
The demand for hedging goes way beyond the food industry. Southwest Airlines (NYSE: LUV ) built an ingenious hedging strategy for fuel costs that helped shelter the company from steadily rising oil prices for years, giving it a competitive advantage over other airlines.
Many consumers in the Northeast do something similar to hedge their winter home heating costs. Oil companies offer fixed-price contracts to customers, guaranteeing a certain price for heating oil no matter how much the spot price may rise during the winter months.
Good news and bad news
Of course, hedging doesn't always work out for companies that use it. Until 2007, Newmont Mining (NYSE: NEM ) and Barrick Gold (NYSE: ABX ) used hedging strategies to lock in future prices for selling the metals they mined. But that meant they missed out on realizing the full benefit of the rise in gold prices, and Barrick ended up spending huge amounts of money to take those hedges off.
Similarly, about a decade ago, Ford Motor (NYSE: F ) used forward purchase contracts to lock in prices of palladium, which it needed to build catalytic converters for its vehicle production. Unfortunately, it locked in at a time when palladium was hitting a peak above $1,000 per ounce. It subsequently slid below $200 before recovering to its current level around $450.
What derivative-based hedging does it allow businesses to take future uncertainty and turn it into a fixed, predictable cost. As long as the counterparties these companies do business with stay solvent, they're protected from adverse price moves.
It's in the way that you use it
Derivatives aren't inherently good or bad. When speculators use them in a way that magnifies their exposure to given markets, they can find themselves in a situation that quickly escalates beyond their control. But for others who need derivatives to hedge their risk exposure, derivatives are a vital financial tool. Any regulation that restricts derivatives without protecting their beneficial uses can only hurt an already fragile economy.
Banks have been notorious derivatives users. Morgan Housel has the latest scoop on how bank earnings are shaping up.