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Derivatives

Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. For example, a call option is a derivative because its value is derived from the value of the underlying stock.  Actually, options are the more complicated of all derivatives.  Most of them are actually quite simple, and come in the form of futures (or forwards).

Types of derivatives

The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the payoffs.

• forward contracts
• futures contracts
• hedging
• swaps

Why use derivatives?

The main reason is to reduce risk, by hedging.  Derivatives are tools that a company can use to cut away its risk, and to sell that risk to another firm (that is in the business of taking risk...like an insurance firm).   Remember, risk is to be avoided in business, and derivatives are one of the main tools for reducing risk.   When a firm reduces its risk using derivatives, it is hedging that risk.  The main use of derivatives is to reduce risk for one party while offering the potential for a high return (at increased risk) to another.

Another use of derivatives is for speculating, or for betting on the future prices of various assets.   This is the opposite of hedging.  If a firm wants to speculate, it is essentially increasing the risk of the firm (hoping for a bigger return).   This is not a very common or recommended strategy for companies that are risk-adverse.  Instead, this type of derivatives speculation is more common with Hedge Funds.  They might make a large one-directional bet that interest rates are going to fall by purchasing a derivate that increases in value when interest rates fall.   This can turn out to be very profitable if you are right, but also very un-profitable if you are wrong.   If you believe in the efficient market theory, then you will agree that its very hard to make money in this manner, but if you believe in behavioral finance, then good luck!

Terminology

1.  Long - benefit if market price of asset goes up 

2.  Short - benefit if market price of asset goes down 

                      Forward     Type        when to use                                example

Book seller:       sells       short        if your hurt by price decrease     selling inventory

Book buyer:       buys       long        if your hurt by price increase       if purchasing for resale (and have fixed sales price)

*See the book seller example for derivatives  for an easy way to think about who is "long", and who is "short"

Links:

• Futures market
• forward exchange rate
• foreign exchange Swaps
• foreign exchange Swaps
• Currency

External Links

• http://en.wikipedia.org/wiki/Derivative_(finance)