What are derivatives?
A derivative is a financial contract with a value that is derived from an underlying asset. Derivatives have no direct value in and of themselves and their value is based on the expected future price movements of their underlying asset.Derivatives can be used for many purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties’ contractual obligations, and the notional amount) under which payments are to be made between the parties.
The most common underlying assets include commodities, stocks, bonds, interest rates and currencies, but they can also be other derivatives, which adds another layer of complexity to proper valuation. The components of a firm’s capital structure, such as bonds and stock, can also be considered derivatives, more precisely options, with the underlying being the firm’s assets, but this is somewhat unusual.
Derivatives have been created to counteract a remarkable number of risks: fluctuations in stock, bond, commodity, and index prices, changes in foreign exchange rates, changes in interest rates and weather events. A commonly used derivative is an “option”. An option is a contract which gives the buyer the right, to buy or sell an underlying asset or instrument at a specified price on or before a specified date. The seller has an obligation to fullfil the transaction, which is to sell or buy if the owner exercises the option.
There are a few types of derivatives such as
- forward contracts
- future contracts
- options contracts
For example, suppose there is a car manufacturer in Japan who is selling cars throughout Japanese soil. When the manufacturer does his research, he finds that buying cars or buying the components to build these cars is quite pricy in Japan and it could incur large expenses and possible losses when selling and when looking at the company’s balance sheets. So, the manufacturer goes to China and sets up a manufacturing line, where the components, cost of labour or any other costs incurred would be far cheaper than it is in Japan. So ultimately what the manufacturer does is to build and export the cars from factories in China and he sells them at a higher price in Japan. This is where the manufacturer would gain from a higher profit margin. He started a contract in two different locations with two different exchanges, bought the cheaper product and sold it at a more expensive price. This is very similar to how derivatives are used in the financial market.
Derivatives can be used on both sides of the coin, to either reduce risk or assume risk with the possibility of a large reward.