Use of derivatives to hedge against risk in a lending context
Use of derivatives to hedge against risk in a lending context

The following Banking & Finance guidance note provides comprehensive and up to date legal information covering:

  • Use of derivatives to hedge against risk in a lending context
  • Hedging against risk in a lending context
  • Hedging against interest rate risk
  • Hedging against exchange rate risk
  • Hedging against commodity price risk
  • The cost of hedging

The most common reasons for entering into derivatives are for the purposes of:

  1. speculation—where a party wishes to gain exposure to a particular variable, eg, speculating on the future price of a commodity in the belief that it is about to go up or down

  2. hedging—where a party wishes to cover its exposure to the risk of an adverse movement in a variable

  3. arbitrage—where a party wishes to exploit a difference in price (on different markets or on the same market over time) to either make a profit or reduce its costs or where one party has access to a price or market that another party cannot access, or

  4. exposure to asset classes—where a party wishes to gain exposure to a particular market (eg commodities, shares, property) without the costs, complications and formalities associated with those markets

Derivatives are often entered into in connection with lending transactions for the purposes of hedging. The ultimate aim of entering into a derivative transaction in this context is to manage cash flow ie balancing the cost of the financing against the borrower's income by eliminating variables that are outside of the control of the borrower. This benefits both the borrower and the lender since the risk of the borrower not being able to repay the loan is reduced.

This Practice Note summarises the most common risks