Derivatives

Derivatives are a common financial tool used in modern financial markets. The primary purpose is to protect investors from fluctuating prices and interest rates. They are financial assets which value derives from other underlying assets.

Purpose

•  Speculating– Traders bet on prices going up/down

•  Hedging – Firms lock in current prices to protect themselves from bad price changes

• Arbitrage – Traders exploit minute price differences to make profit

Speculating – profiting from price moves, done by traders

Traders use derivatives to predict price movements. Derivatives are used to give them access to asset returns without actually owning them.

Hedging – used for protection

Firms use derivatives to prevent losing money if prices move against them

Examples:

Airline fuel

Airlines lock in current fuel prices for a time period to prevent losing out if fuel prices rise

Payment

• A UK company is getting paid $1M in 1 month

• If pound the pound rises, $1M converts to less GBP

• They lock in today’s USD/GBP rate to prevent potential loss

Arbitrage – exploiting price mismatches to gain risk-free profit, occurs in milliseconds

This is the same process as arbitrage in ordinary assets but derivatives are traded instead.

I hope this short piece helped explain the main reasons behind using derivatives. I have another two pieces on them coming out shortly so keep your eyes peeled here!