Share Market

Derivatives are related with future performance and speculation of a certain market. Examples of derivatives would be futures, contracts, swaps, forwards and more. Derivative is a mere contract between two or more parties. The value of this derivative is determined by the market fluctuations in respect to underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Derivatives are used as an instrument to hedge risk, but can also be used for speculative purposes. To hedge this risk, the investor usually would purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into the currency he had. They are contracts that one needs to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined at real time. The contract may be binding on either the parties or just one party with the other party reserving the option to exercise or not.

In usual case, the underlying asset either has to be traded or some kind of cash settlement has to exist. Derivatives are traded either in organized exchanges or over the counter. They are important in the world of finance because they allow for hedging and managing risk. They are one of the fastest growing segments in the financial market.

Since derivatives have no value themselves and are dependent on the value of another asset, there is a larger risk associated with them. They do lead to quick profits but they just cannot be trusted. Derivatives can best be taken up by those who understand thoroughly the relationships between product volume, price trends and consumer interest.

There is a very interesting example to understand the significance of derivatives. If we take up the case of Japanese rice farmers and the rice warehouse merchants then we’d know exactly how it all works. A rice farmer could sign a contract with a merchant in the spring that would allow the merchant to pay the farmer a certain set amount of cash. In exchange for the immediate cash, the rice farmer would deliver a certain amount of rice after the harvest. In this case, the rice farmer has lowered the business risk because he has received a certain price for the rice, while the merchant has locked in the price for a certain amount. Shortage or overabundance of rice would decide the wisdom in the exchange.