Derivatives

Definition

Derivatives are financial instruments whose value is derived from the performance of an underlying asset, index, or other investment. They are used to manage risk, speculate on market movements, or create complex trading strategies.

5 Must Know Facts For Your Next Test

1. Derivatives can be used to hedge against risks in financial markets, such as changes in interest rates, exchange rates, or commodity prices.
2. The value of a derivative is derived from the underlying asset, which can be a stock, bond, currency, or commodity.
3. Derivatives can be traded on exchanges or over-the-counter (OTC) between two parties.
4. Leverage is a key feature of derivatives, allowing investors to gain exposure to a large underlying asset with a relatively small initial investment.
5. Derivatives can be used to speculate on market movements, creating opportunities for both profits and losses.

Review Questions

• Explain how derivatives can be used to manage risk in financial markets.
  • Derivatives can be used to hedge against various risks in financial markets, such as changes in interest rates, exchange rates, or commodity prices. For example, a company that needs to make a future payment in a foreign currency can use a currency forward contract to lock in the exchange rate, protecting itself from unfavorable currency fluctuations. Similarly, an investor concerned about a potential decline in stock prices can use options contracts to limit their downside exposure while still maintaining upside potential.
• Describe how the use of leverage in derivatives trading can amplify both profits and losses.
  • Derivatives often involve the use of leverage, which means that investors can gain exposure to a large underlying asset with a relatively small initial investment. This leverage can amplify both profits and losses. For instance, an investor who buys a call option on a stock may only need to pay a fraction of the stock's price to gain the right to buy the stock at a predetermined price. If the stock price rises, the value of the option will increase significantly, leading to substantial profits. However, if the stock price falls, the option may become worthless, resulting in the loss of the initial investment. The leverage inherent in derivatives can thus magnify the potential rewards, but also the potential risks, of trading in these financial instruments.
• Analyze the role of derivatives in the foreign exchange market and how they can impact the demand and supply of currencies.
  • Derivatives play a crucial role in the foreign exchange market, as they allow market participants to manage currency risks and speculate on exchange rate movements. For example, a company that needs to make a future payment in a foreign currency can use a currency forward contract to lock in the exchange rate, effectively hedging its currency exposure. This can impact the demand and supply of the underlying currencies, as the forward contract creates additional demand for the currency that the company needs to purchase. Conversely, speculators who use currency futures or options to bet on exchange rate changes can also influence the demand and supply of currencies, as their trading activity can drive prices up or down. The widespread use of derivatives in the foreign exchange market can thus have a significant impact on the overall dynamics of currency demand and supply.

Related terms

Futures Contract: A standardized agreement to buy or sell an asset at a predetermined price and future date.

Options Contract: A contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain time period.

Swaps: A derivative contract in which two parties agree to exchange one stream of cash flows for another, based on a specified notional amount.