What Are Derivatives?
Derivatives are financial contracts whose value derives from an underlying asset, such as stocks, bonds, commodities, currencies, or interest rates. They allow investors to speculate on price movements or hedge risks without owning the asset. In financial markets, derivatives are traded on exchanges like the CME or over-the-counter (OTC), enabling leverage and efficiency.
Key Types and Mechanics
Common derivatives include futures (standardized contracts to buy/sell at a future date and price), options (rights to buy/sell at a strike price), swaps (exchanging cash flows), and forwards (customized OTC futures). They work through agreements on future obligations or rights, with prices determined by supply, demand, and the underlying asset's value. Settlement can be physical (delivering the asset) or cash-based.
Practical Example: Using Futures
Consider an airline hedging fuel costs with crude oil futures. If oil is $80/barrel and the airline expects prices to rise, it buys futures contracts locking in $80. If prices climb to $100, the airline profits $20/barrel on the contract, offsetting higher spot market costs. Conversely, a speculator might sell futures betting on a price drop, profiting if correct.
Importance and Real-World Applications
Derivatives enhance market liquidity, price discovery, and risk management, vital for global trade and investment. They help farmers secure crop prices, corporations manage currency risks, and investors amplify returns. However, misuse can lead to losses due to leverage, as seen in the 2008 crisis, underscoring the need for regulation and understanding.