Financial Derivatives Investing

Most people became aware of derivatives because of their role in the global financial crisis. Some believe that these derivatives are very destructive to financial markets. They are more complicated than bonds or stocks, but danger to investors and the economy is dependent on whether they're used to bet or hedge. Derivatives are assets that get their value from other assets, such as futures. With a futures contract, one entity agrees to buy a specific amount of a product at a set price on a set date. The contracts are traded on an exchange, and the contract value is determined by the price of the product. Most investors use derivatives as a hedge- a way to reduce their risk. For instance, a farmer can buy a pork futures contract to ensure that his livestock sell for a good price. A pork wholesaler will buy the other end of the derivative to make sure he can buy at a good price. Between the time that the contract is sold and settled, the price of the product can rise or fall. If it is higher at settlement time, the farmer has to sell his pigs at a lower price but he still gets the benefits. The wholesaler also benefits because he got his livestock at below market price. When derivatives are used as hedges, they carry some risk to the value of the asset. Derivatives work like insurance, protecting both buyer and seller from loss. As a matter of fact, insurance can be regarded as a derivative; the value of having it increases if you need it and it declines if you do not have to file a claim. When used as a hedge, derivatives work like insurance, but when they are used as a tool for speculation, they are much like placing a bet. If a speculator believes that the price of an asset will decline, he won't do business with that product. Rather,they'll place a bet on the futures market, buying a contract to sell the product at a future date. Using a derivative as a speculation tool has the opposite effect of using them as a hedging tool. As opposed to reducing risk, a speculator is assuming it. There are many kinds of derivatives- futures, options, swaps and forwards. All of these have different and complex ways to shift the risk, and they are not direct investments. Derivatives can be used as a risk-reduction tool, or they can be used to assume risks where none were present before.