Many a times when you think of derivatives, the first thing that strikes your mind is the reduction of risk involvement, the simple ways of tracking it, the volatility of the market affecting your financial instrument, the speculations and the hedging involved in it. But a derivative market is much more than that. If you have researched about it you will come to know about it.
We have all heard how derivatives have an impact on the economy, we will today learn more about the derivatives which are very lucrative and valuable in nature.
Let’s take couple of examples to understand what exactly derivatives are.
Two farmers, one of them growing wheat and the other growing corn, come together and decide to trade three sacks of wheat for three sack of corn. In this way, they are just trying to steady the value of both the crop, regardless of what may the actual cost in the market. It also does not consider the supply and the demand of the products.
Let’s take an example of a nation producing oil and a firm into oil brokering, here in this case – when they come to trade, they do not base it on exchange. Here, the contract is just based on the trading of oil and no exchange of anything else. However; one barrel of oil will be traded against dollar.
In this case, as the cost of oil kept increasing the brokering company would have noticed the trend and must have fixed a value to buy oil. For example, if they decided to pay $60 throughout the year, and the barrel prices increase to $100 the oil brokering company would still pay $60 thereby gaining profit, but it can also affect them badly if the prices turn towards a downward trend. This is what we call a forward contract in the financial markets.
Another derivative type, which has caused a lot of issues in the current economy, is the credit swap. Let’s take an example, everyone must have heard of sub prime crisis. The credit started getting swapped from sub prime loaners to investment brokers and eventually to different investment firms. What happened because of this, the paper worth of the mortgaged houses reduced and in the meanwhile, a lot of home buyers started defaulting on their loans. This particular phenomenon grew out of proportion and attributed to the fall of big and old financial institutions.
So if you ask me what is a derivative, in simple terms it can be said as a contractual agreement between two different parties, where the worth of commodity or the services offered, will be given to you by the other person. The best help of this is the risk gets minimized and transferred to both the parties. However, as we have seen the crisis of US economy unfolds, it is essential to think and invest. Derivatives are good option, but we need to be precarious while using this form of financial investments as on a given day it can prove really beneficial to us, however; if you do not make a good decision, it can also be the cause for a lot of troubles.