How are Derivatives Used?

Derivatives are used commonly in two ways, either via hedging (managing risks) or by speculating (presuming the risk with the expectation of equal returns). The value of the underlying assets varies according to market conditions. The main purpose for engaging in derivative contracts is to generate revenue through predictions of the underlying asset’s potential future value.

1. Risk Management: The financial risks are managed using the derivatives. To safeguard from the risk of declining prices, a farmer, for instance, might use a futures contract to seal in a price for crops (say rice) before they are harvested. In this way, the farmer protects itself from the market fluctuations.

2. Speculation: With the help of derivatives, investors speculate to earn profit from the price movements in the underlying assets without actually owning them. Suppose, purchasing futures or options contracts to capitalize on anticipated market changes.

3. Hedging: Derivatives are used by investors or businesses to hedge against adverse price fluctuations. For instance, an MNC that deals in diverse currencies may use currency derivatives to minimize the impact of exchange rate fluctuations on its profits.

Derivatives are a form of special financial instrument where the value of these instruments is derived from an underlying asset or an index. As the name goes, derivatives are linked to some form of financial instrument, indicator, or commodity. Some commonly used assets include stocks, bonds, commodities, currencies, and market indices. Initially, these underlying assets are created using any individual security or a combination of securities. As the value of these securities changes, the value of the derivatives also keeps changing. Derivatives are those complex instruments used in trading risk in the financial markets by either hedging, speculating, or arbitraging. Derivatives form the basic concept under consideration in financial engineering. The primary purpose of derivative contracts is to generate profit by speculating the future value of the underlying asset.

Geeky Takeaways:

• Derivatives are financial contracts where the value is determined based on the underlying stocks, bonds, commodities, or certain market indices. In simple words, predicting and agreeing to a future value of an underlying asset.
• These financial contracts are used by hedgers, speculators, arbitrageurs, and margin traders for risk management, hedging, speculation, and arbitrage among different markets.
• Derivatives are traded in two platforms either via over-the-counter (OTC) trading or via a standardized exchange.
• These contracts can take either simple or complicated forms of options, futures, forwards, swaps, or warrants.