Derivatives

Definition

Derivatives are financial instruments whose value is derived from the performance of an underlying asset, index, or other financial instrument. They are used to manage risk, speculate on market movements, or create complex investment strategies.

5 Must Know Facts For Your Next Test

1. Derivatives can be used to hedge against risk, speculate on market movements, or create complex investment strategies.
2. The most common types of derivatives are futures, options, and swaps, which are traded on exchanges or over-the-counter (OTC) markets.
3. Derivatives allow investors to gain exposure to an underlying asset without having to own the asset directly.
4. Derivatives can be used to leverage investment positions, amplifying both potential gains and losses.
5. Regulation and oversight of the derivatives market have increased in recent years to address concerns about systemic risk and market stability.

Review Questions

• Explain how derivatives are used in the context of financial management and securities markets.
  • Derivatives play a crucial role in financial management and securities markets. They allow investors and businesses to manage risk by hedging against potential losses in the underlying asset. For example, a company that exports goods may use currency derivatives to protect against fluctuations in exchange rates. Additionally, derivatives can be used to speculate on market movements, creating opportunities for investors to profit from changes in the prices of assets like stocks, bonds, or commodities. In the securities markets, derivatives such as options and futures are actively traded, providing liquidity and price discovery for the underlying assets.
• Describe the different types of derivatives and their key features.
  • The three main types of derivatives are futures, options, and swaps. Futures contracts are standardized agreements to buy or sell an asset at a predetermined price and date in the future. Options contracts give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain time period. Swaps are derivative contracts where two parties agree to exchange one stream of cash flows for another, based on a specified notional amount. These different derivatives have unique characteristics that make them suitable for various risk management, speculative, and investment strategies in the financial markets.
• Evaluate the role of derivatives in the context of trends in financial management and securities markets, and discuss the potential risks and benefits associated with their use.
  • Derivatives have become increasingly important in financial management and securities markets, driven by factors such as globalization, volatility in asset prices, and the need to manage risk. Derivatives allow investors and businesses to hedge against various risks, such as changes in interest rates, exchange rates, or commodity prices. This can help stabilize cash flows and protect against potential losses. However, the use of derivatives also carries risks, including the potential for leverage to amplify both gains and losses, the complexity of some derivative products, and the systemic risk that can arise from the interconnectedness of derivative markets. Regulators have sought to address these concerns by increasing oversight and implementing measures to enhance transparency and stability in the derivatives market. Overall, the role of derivatives in financial management and securities markets continues to evolve, with both benefits and risks that must be carefully considered.

Related terms

Futures Contract: A standardized contract to buy or sell an asset at a predetermined price and date in the future.

Options Contract: A contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain time period.

Swap: A derivative contract in which two parties agree to exchange one stream of cash flows for another, based on a specified notional amount.