Derivatives - End Users and Dealers

End users of forward contracts vary across a broad range of sectors. In general, end-users have specific risk management concerns that can be mitigated by an appropriate forward contract. However, because forward contracts are not found on a formal exchange, end-users must find a counterparty to their contracts. A dealer is used find a complimentary counterparty that can provide a financial transaction to solve the problem. The problem could be that the end user wants to reduce or eliminate risk or just wants to take a position on the way the market may move in the future. End users are typically corporations, nonprofit organizations and governments. Below are two examples of situations in which end-users can mitigate risk with forward contracts.

An engineering firm based in Rome, Italy, has a contract with an American company for six months of work. The Italian company is being paid in two installments: the first payment at the start of the contract and the final payment on the closing date of the contract. The Italian company arranges a closed forward contract for the final payment. This protects the company against currency fluctuations and establishes how much the company will receive in euros for its final payment. This allows the company to avoid losing revenue unexpectedly as a result of rate fluctuations.

An importer in Chicago is bringing in a line of ceramics from Spain. The stock is due to arrive in the U.S. in three shipments over the next two months. Because the importer will pay for each shipment on arrival, the importing company arranges for an open forward contract equal to the value of the entire order in euros. The open contract allows the importing company to make a series of payments by drawing down on the contract amount throughout the contract period. Thanks to the forward contract, the importer knows exactly how much it needs to pay for the shipment in U.S. dollars, rather than having this amount change due to rate fluctuations between the time it books the order and when the shipment arrives.

Farmers, manufacturers, importers and exporters are typical end-users who hedge their positions by buying or selling in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market.

Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and maximize their profits. Unlike the hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts.

Dealer
A dealer helps facilitate the trading and structure of these transactions based on the end user's specific needs and goals. Dealers may take the other side of the trade for the end user or a dealer may find another counterparty that has the exact opposite needs of the end user. A dealer differs from an agent in that it takes ownership of the asset, and thereby is exposed to some risk. A dealer has ownership, even if only for an instant, between a purchase from one party and a sale to another party, and is thus compensated by the spread between the price paid and the price received.
Individuals or firms may act as either a broker or a dealer in separate transactions. This helps the dealer reduce the end user's risk from derivatives and may allow the dealer to earn additional revenue by buying and selling these contracts with his clientele. Dealers tend to be broker/dealers and/or large global banking institutions such as JP Morgan Chase, Citigroup and UBS Warburg to name a few of them.

Equity Forward Contracts


Related Articles
  1. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    Pass Your CFA Exams on the First Try

    Become one of the elite who pass these exams by using these simple study methods.
  3. Financial Advisors

    MBA or CFA: Which Is Better for a Career in Finance?

    Potential financial advisors, analysts or asset managers have many credentials and degrees from which to choose. Here's a look at the CFA vs. the MBA.
  4. Your Practice

    Is it Too Easy to Become an RIA?

    If you want to become an RIA all you have to do is pay a $165 fee to the SEC and pass the Series 65 exam. Is the bar set too low?
  5. Professionals

    How to Prepare for the CFA Exams

    To pass the CFA exam, get organized, develop an effective study program and review.
  6. Professionals

    So, You Want to Earn Your CFA?

    Here are some pros and cons to consider before you take the CFA charter plunge.
  7. Professionals

    How To Land A Finance Job With A Bachelor’s Degree

    Finding that first finance job is not easy, but these five tips can boost your chances even before you graduate.
  8. Professionals

    Finding The Right Accounting Certification

    The right accounting certification can open the doors of opportunity.
  9. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  10. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
RELATED TERMS
  1. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  2. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  3. CFA Institute

    Formerly known as the Association for Investment Management and ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    Understand the differences between a Chartered Financial Analyst and a Certified Financial Planner. Learn how each approaches ... Read Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    Understand what it means to hold the Chartered Financial Analyst designation. Learn how a candidate can work to become a ... Read Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    Understand what types of positions a Chartered Financial Analyst can hold. Learn what is available to those who have only ... Read Answer >>
  4. Who benefits the most from prepaid expenses?

    Learn who benefits most when expenses are prepaid. Individuals and businesses often make payments, such as rent or insurance, ... Read Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Answer >>
Hot Definitions
  1. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  2. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  3. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  4. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  5. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  6. Economies Of Scale

    Economies of scale is the cost advantage that arises with increased output of a product. Economies of scale arise because ...
Trading Center