Hedging & Derivatives

Derivatives — futures, options, swaps and the structured products built from them — are the primary tools risk managers use to transfer unwanted exposure. This hub covers how these instruments work and how hedges are designed and sized.

How it works

A derivative takes its value from an underlying — a commodity, rate, currency or index — and lets a firm transfer risk without owning the underlying. The core building blocks are futures and forwards (an obligation to buy/sell later at an agreed price), options (the right, not the obligation) and swaps (exchanging one cash-flow stream for another). Futures and standardised options trade on exchanges and are centrally cleared; forwards and most swaps are over-the-counter (OTC). A hedge simply takes an offsetting position — a producer selling futures against future output, say — trading away price risk in exchange for basis risk, cost and margin obligations.

In practice

OTC derivatives are documented under the ISDA Master Agreement, standardised since 1987, with a Credit Support Annex (CSA) governing collateral (initial and variation margin). The market is enormous — around US$846 trillion in notional outstanding at mid-2025 — but that figure overstates true risk: close-out netting reduces mark-to-market exposure by roughly 86%. Good hedge design is therefore as much about managing basis risk and the funding of margin calls as about the headline price protection.