Derivatives: function and possible uses

Derivatives: function and possible uses

Derivatives: function and possible uses

Derivatives are complex financial instruments that derive their value from an underlying asset. They allow investors to speculate on price movements or other changes in the underlying asset without having to own the underlying asset itself. Derivatives have a variety of possible uses and are used by private investors, companies and institutional investors alike.

What are derivatives?

Derivatives are financial instruments whose value depends on the value of an underlying asset. This asset can be, for example, a stock, an index, a currency or a commodity. Derivatives can be traded in the form of options, futures, swaps or other contracts.

The main difference between derivatives and other financial instruments is that derivatives have no intrinsic value. Instead, they derive their value from another asset. Derivatives are therefore derivative financial instruments.

Functions of derivatives

Derivatives have different functions and possible uses. Some of the most important features are explained in more detail below.

Hedging

One of the main functions of derivatives is to hedge risks. Companies can use derivatives to hedge against unfavorable price movements. Suppose a company imports raw materials from abroad and is therefore exposed to exchange rate risk. It can use derivatives to hedge against foreign currency appreciation and thus stabilize its costs.

Investors can also use derivatives to hedge their stock portfolio. For example, if they think the market might fall, they can use derivatives to hedge their stock positions and limit losses.

Speculation and trading

Derivatives are often used for speculative purposes. Investors can use derivatives to speculate on price movements of an asset and make profits. Because derivatives are typically leveraged, even small market movements can result in large profits or losses.

An example of this is options trading. An option gives the buyer the right to buy or sell an underlying asset at an agreed price. If an investor thinks that the price of a particular asset will rise, he or she can purchase a call option. If the price actually rises, he can exercise the option and buy the underlying asset at a lower price, then sell it at a higher price and make a profit.

Price determination

Derivatives are also used to determine the price of the underlying asset. Depending on the type of derivative and the underlying asset, derivatives can help determine the fair market price of the asset.

An example of this are futures contracts on raw materials such as oil or gold. When derivatives traders bring their expectations about a particular asset into trading, it can help determine the market price of that asset.

Types of derivatives

There are a variety of derivatives that can be traded. The most common types of derivatives are options, futures, swaps and forwards.

Options

Options give the buyer the right to buy or sell an asset at a set price (the strike price) in the future. There are two types of options: call options and put options. A call option gives the buyer the right to buy the asset, while a put option gives the buyer the right to sell the asset.

Futures

Futures are standardized contracts that provide for the purchase or sale of a specific asset at a future date and at a specified price. Futures are often used to hedge price risk, but are also popular instruments for speculative purposes.

swaps

Swaps are financial agreements in which two parties agree to exchange cash flows during a specific period of time. For example, an interest rate swap may require two parties to exchange interest payments on certain debts.

Forwards

Forwards are similar to futures, but not standardized. They are tailored contracts agreed between two parties that provide for the purchase or sale of an asset at a future time and price.

Risks of Derivatives

Derivatives may involve certain risks that investors should be aware of. The most common risks are:

– Price risk: The value of derivatives can be volatile and is highly dependent on price movements of the underlying asset.
– Credit risk: If one of the parties to a derivative transaction becomes insolvent, this may result in losses for the other party.
– Liquidity risk: Some derivatives markets may be illiquid, which may make trading difficult.
– Leverage: Derivatives are often leveraged, meaning investors only have to invest a portion of the total value. This can result in high profits, but also high losses.

It is important that investors understand the risks before investing in derivatives. It is recommended to do thorough research on the underlying asset, the derivative and the underlying market sentiment.

Conclusion

Derivatives are complex financial instruments that derive their value from an underlying asset. They offer investors a variety of features and uses, including hedging, speculation and price discovery. There are different types of derivatives including options, futures, swaps and forwards. However, it is important to be aware of the risks associated with derivatives. Investors should inform themselves thoroughly and, if necessary, seek professional advice before investing in derivatives.

Frequently asked questions

What are derivatives?

Derivatives are financial instruments whose value is derived from another asset.

What functions do derivatives have?

Derivatives have various functions including hedging risks, speculation and price discovery of the underlying asset.

What types of derivatives are there?

There are different types of derivatives including options, futures, swaps and forwards.

What risks are associated with derivatives?

Derivatives may involve price risk, credit risk, liquidity risk and leverage.

Should I invest in derivatives?

Derivatives are complex financial instruments and involve certain risks. It is recommended that you do thorough research and, if necessary, seek professional advice before investing in derivatives.