Derivatives

Definition

Derivatives are financial contracts whose value is linked to the price of an underlying asset, such as stocks, bonds, currencies, or commodities. They serve as risk management tools, allowing businesses and investors to hedge against potential price fluctuations. By providing a way to speculate on future price movements or to lock in prices, derivatives play a crucial role in capital markets and are widely used by financial intermediaries to facilitate trade and investment.

5 Must Know Facts For Your Next Test

1. Derivatives can be used for hedging purposes, allowing businesses to reduce their exposure to adverse price movements in underlying assets.
2. They can also be used for speculation, enabling traders to profit from expected changes in asset prices without actually owning the assets.
3. The two main types of derivatives are exchange-traded derivatives and over-the-counter (OTC) derivatives, with the former being standardized and traded on exchanges while the latter are customized contracts negotiated directly between parties.
4. The value of derivatives is often influenced by factors such as market volatility, interest rates, and time to expiration.
5. Regulation of derivatives has increased following financial crises, with authorities aiming to improve transparency and reduce systemic risk in financial markets.

Review Questions

• How do derivatives function as risk management tools in financial markets?
  • Derivatives function as risk management tools by allowing businesses and investors to hedge against potential price fluctuations in underlying assets. For instance, a company expecting to receive foreign currency may use currency derivatives to lock in exchange rates, protecting itself from unfavorable movements. This ability to transfer risk plays a vital role in stabilizing financial markets and supporting investment decisions.
• Discuss the differences between options and futures as types of derivatives.
  • Options provide the holder with the right, but not the obligation, to buy or sell an underlying asset at a specific price within a certain timeframe, offering flexibility. In contrast, futures contracts obligate both parties to execute the transaction at a predetermined price on a specified future date, making them binding agreements. These differences make options more suited for speculative strategies while futures are commonly used for hedging and locking in prices.
• Evaluate the impact of increased regulation on the derivatives market following financial crises.
  • Increased regulation of the derivatives market post-financial crises has led to greater transparency and reduced systemic risks within financial systems. Regulatory measures often require more standardized contracts and reporting requirements for OTC derivatives. While this has helped mitigate risks associated with opaque trading practices, it has also raised concerns about liquidity and compliance costs for market participants. Overall, while regulations aim to enhance stability, they may also alter how derivatives are traded and utilized within capital markets.

Related terms

Options: Options are a type of derivative that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified timeframe.

Futures: Futures are standardized contracts obligating the buyer to purchase, and the seller to sell, an asset at a predetermined price on a specified future date.

Hedging: Hedging is an investment strategy used to offset potential losses in another investment by taking an opposite position in a related asset.