Why do businesses use derivatives?
Derivatives help companies manage risk and are increasingly used by firms seeking to protect themselves from the the volatility of financial markets.
The most common use for derivatives is to manage the risk of foreign currency fluctuations. For firms relying on imports, such as those that import raw materials, tools like futures and forwards allow them to lock in an agreed exchange rate in advance, which makes it easier to plan and manage cashflows. Similarly, exporters can use these tools to lock in an exchange rate at a future sale date, enabling them to better plan their cashflows.
Another common use of derivatives is to guard against changes in interest rates, or to take advantage of more favourable interest rates that a firm may not be able to access on their own. For instance, a firm that has a variable interest rate on a loan may enter into a swap which allows them to swap their variable interest payments for fixed interest rate repayments. Similarly, a company locked into a fixed interest rate may be able to save money by entering a swap which allows them to repay at a variable market rate.
The third most common use is using these tools to manage commodity-price fluctuations. For companies that rely on primary commodities such as coffee beans or grain, price fluctuations can be very problematic. Derivatives allow such companies to lock in a price for a future sale or purchase of goods.
Presumably KCDC used the second form. It is gambling on movements in interest rates, and losing. Councils should have nothing to do with derivatives. one would hope they sought expert advice. A question the new set of councilors will need to ask: If the experts were negligent, can KCDC sue them for sustained losses?