Share markets across the world are flooded with different types of financial instruments. Instruments because they directly do not give us money, but acts as a channel to gain money. Today let us discuss in detail about financial derivatives.
In chemistry, the definition of derivatives states that these are substances which are created from another substance. Similarly in the financial markets derivatives are financial instruments which are based on an already existing act and which allow value exchange.
In this, the stock holder enters into a deal with a person, who is ready to buy the stock at a recognized price or at a different price in the near future. However; amongst both the latter part is the most popular one.
There are specific roles that are a part of financial derivatives
Speculation and Hedging
Hedging: In Hedging, financial derivatives act as a financial instrument to transfer risk. However; the transfer of risk is only possible if there is stock or underlying asset already existing, else in no ways can you transfer the risk. Let’s take an example, in case of a lifts manufacturer; he is assured of hedging process as he will receive money from the lifts manufacturer supplier. And the electricity supplier is also sure that electricity will be available to him through the help financial derivative.
So the thing that has cleared happened for both the parties is that risk has been minimized. Derivatives play a pivotal role in hedging because they are uncomplicated and don’t require any form of balance sheet calculations. The products in derivatives can be put up, without regarding the fact that these products actually cease to exist in reality.
The benefits of hedging are:
1)It is uncomplicated to handle.
2)The risk is minimized for both the parties.
3)The traders can take the risk, without actually buying the future stock.
Speculations : In short, speculation is nothing but plain speculative trading, where in you just speculates what could be the possible cost of share or an asset. There are many financial institutions who firmly believe that they can speculate the trend of a particular stock or financial instruments. Directional playing is how they understand this term as. Apart from this speculation can be done based on the volatility of the security.
Many of the firms have been found making use of financial derivatives as a source to reduce the risk involved. Because of the minimizing risk factor derivatives are probably one of the most popular financial instruments available in the financial market today. Apart from reducing the risk, some firm also uses financial derivatives to reduce the tax liability of the firm. But it has its own consequences, there are certain times it may do well for you, but the other time it can fall flat on your face.
So you need to some kind of research before using it as source of using it as instrument to reduce tax liability. A word of caution before investing learn and read about financial derivatives as an instrument of money as it will be beneficial to you for your own profits and losses.