A financial derivative is a financial contract whose value is derived from the performance of an underlying
asset, index, or rate. The underlying assets can be stocks, bonds, commodities, currencies, interest rates, or
market indexes. Derivatives allow participants to speculate on or hedge against future price movements
without directly owning the underlying asset.
Purpose of Financial Derivatives
1. Hedging: Investors and companies use derivatives to reduce or manage the risk associated with the price
fluctuations of underlying assets. For example, a company that relies on oil can use oil futures contracts to
lock in prices and avoid the risk of future price spikes.
2. Speculation: Traders use derivatives to bet on the future price of assets, seeking to profit from price
movements without needing to own the asset itself.
3. Arbitrage: Investors may use derivatives to exploit price discrepancies in different markets or between
related financial instruments, earning risk-free profits from these differences.
Types of Financial Derivatives
1. Futures Contracts: A standardized contract to buy or sell an asset at a specified price on a future date.
Futures are traded on exchanges, and both parties are obligated to fulfill the contract at maturity.
2. Forward Contracts: Similar to futures but customized contracts between two parties that are not traded on
exchanges. They are private agreements and can be tailored to the needs of the participants.
3. Options: A contract that gives the holder the right (but not the obligation) to buy or sell an asset at a
predetermined price within a specific period.
Call Option: Gives the right to buy.
Put Option: Gives the right to sell.
4. Swaps: Contracts in which two parties exchange cash flows or financial instruments. Common types
include:
Interest Rate Swaps: Parties exchange fixed interest rate payments for floating-rate payments.
Currency Swaps: Exchange of principal and interest in one currency for the same in another currency.
5. Credit Derivatives: Financial instruments used to manage credit risk, such as credit default swaps (CDS),
where one party pays the other in the event of a default on a debt instrument.
Key Participants in the Derivatives Market
1. Hedgers: These participants use derivatives to reduce or eliminate the risk associated with the price
movement of an asset they own or plan to own. For example, a farmer might hedge the price of crops using
futures to secure an income despite market volatility.
2. Speculators: These are traders who seek to profit from the price changes in the underlying assets.
Speculators are willing to take on higher risk in exchange for the possibility of higher returns.
3. Arbitrageurs: They aim to profit from price differences between markets or assets. By buying in one
market and selling in another, they exploit inefficiencies in pricing to earn risk-free profits.
4. Market Makers: These participants provide liquidity to the market by being willing to buy and sell
derivatives, ensuring that others can trade more easily. They earn profits from the bid-ask spread.
5. Corporations and Financial Institutions: Large companies and banks often use derivatives to manage their
financial risks, such as changes in interest rates, currency exchange rates, or commodity prices.
