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Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.
Derivatives traders at the Chicago Board of TradeDerivatives can serve legitimate business purposes. For example, a corporation borrows a large sum of money at a specific interest rate.[11] The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money.[12] If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.
[edit] Speculation and arbitrageDerivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.
Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[13]
