Derivatives are financial instruments. They do not have a intrinsic value as they are derived from the value of another commodity, this could be coffee or another financial instrument example a share.
We can trace back the development of derivatives to the commodities markets. Traders bought and sold ‘futures contracts’. The purpose of these instruments is to lessen risk and hedge against certain types of risk.
For example a farmer who grows wheat may wish to sell his crop six months before it is harvested – the farmer would enter into a contract with a buyer to sell the crop at a specified price in six months time. This simple explanation outlines a ‘futures contract’.
In the developed financial markets the trading of derivatives and in particular futures contracts has become wide spread. You can buy any type of derivative contract involving simple and exotic underlying assets.
As described the purpose of derivatives is to lessen risk however for companies and organizations buying or involved in trading these instruments the risk levels can be catastrophic. Barings banks was effectively bankrupted by unauthorised trading in the Simex futures market.
There are four main types of contracts:
- Forward Contracts
The purpose of these instruments are:
Lessen risk by transferring risk from one person to another.
Arbitrage a process of making a profit by exploiting small price differences in different markets.
Speculators can build large exposures with little capital.
Hedging risk against an exiting assets, traders can utilize derivatives to hedge against there positions.
This type of trading is not for the amateur investor as the losses can be enormous.