Final answer:
Derivatives are financial tools used by companies to manage risk; they can mitigate or amplify risks depending on their use.
Step-by-step explanation:
Derivatives are financial instruments that get their value from an underlying asset or event. When used strategically, derivatives serve as a powerful tool for managing a variety of financial risks. For example, they can be employed as hedging instruments to reduce the exposure to fluctuations in interest rates, currency exchange rates, or commodity prices. Companies can enter into futures contracts, options, swaps, and forward contracts, each with its unique method of risk mitigation.
From the literature standpoint, derivatives can effectively decrease corporate risk by providing certainty about future costs or revenues. Companies can lock in prices for commodities or secure favorable exchange rates in advance through such contracts. On the other hand, if not used judiciously, derivatives can also increase risks, particularly if they are used for speculative purposes rather than hedging. The mismanagement of derivatives, lack of proper understanding, or insufficient regulation, as highlighted by the failure of mortgages cited in our reference, can lead to significant financial losses and systemic risks.
In conclusion, the role of derivatives in a company's risk profile is twofold. If understood and managed properly, they can serve as insurance against potential losses, but if misused, they can elevate the financial risk and lead to catastrophic losses.