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Investment - Functions of Derivative Contracts
Uses of Derivatives Contracts
Derivatives can be established on any asset, event, or outcome, which is called the underlying. The underlying can be a physical item, such as wheat or gold, or a financial asset, such as the share of a firm. The underlying can also be a wide market index, such as the S&P 500 Index or the FTSE 100 Index.
The underlying can additionally be an outcome, such as a day with temperatures under or over a specific temperature (known as heating and cooling days), or an event, such as bankruptcy. Derivatives can be used to reduce risks connected with the underlying, but they may result in higher risk exposure for the other party to the contract.
Let’s continue the narrative of the wheat farmer. The farmer anticipates having at least 50,000 bushels (approximately 136 metric tons) of wheat available for sale in mid-September, six months from now.
A bushel of wheat is currently selling in the market at USD9.00, which is the spot price. The farmer has no means of knowing what the market price of wheat will be in six months.
The farmer finds a cereal producer that wants wheat and is willing to contract to buy 50,000 bushels of wheat at a price of USD8.50 per bushel in six months. The contract provides a hedge for both the farmer and the cereal producer. A hedge is an action that decreases uncertainty or risk.
But what if the farmer cannot find someone who genuinely needs the wheat? The farmer might still find a counterparty that is willing to engage into a contract to buy the wheat in the future at a price agreed on today. This counterparty may anticipate being able to sell the wheat at a greater price in the market than the price agreed on with the farmer. This counterparty may be labeled a speculator.
This counterparty is not hedging risk but is instead taking on risk in anticipation of receiving a return. But there is no guarantee of a positive return. Even if the future price in the market is lower than the price agreed on today with the farmer, the counterparty needs to buy the wheat at the agreed-on price and later may have to sell it at a loss.
Derivatives allow corporations and investors the flexibility to manage future risks connected to raw material costs, product pricing, stock prices or indices, interest rates, exchange rates, and even uncontrollable phenomena, such as weather. They also allow investors the chance to obtain exposure to underlying assets while committing much less capital and incurring fewer transaction costs than if they had invested directly in the assets.
Uses of Derivatives Contracts
Derivatives can be established on any asset, event, or outcome, which is called the underlying. The underlying can be a physical item, such as wheat or gold, or a financial asset, such as the share of a firm. The underlying can also be a wide market index, such as the S&P 500 Index or the FTSE 100 Index.
The underlying can additionally be an outcome, such as a day with temperatures under or over a specific temperature (known as heating and cooling days), or an event, such as bankruptcy. Derivatives can be used to reduce risks connected with the underlying, but they may result in higher risk exposure for the other party to the contract.
Let’s continue the narrative of the wheat farmer. The farmer anticipates having at least 50,000 bushels (approximately 136 metric tons) of wheat available for sale in mid-September, six months from now.
A bushel of wheat is currently selling in the market at USD9.00, which is the spot price. The farmer has no means of knowing what the market price of wheat will be in six months.
The farmer finds a cereal producer that wants wheat and is willing to contract to buy 50,000 bushels of wheat at a price of USD8.50 per bushel in six months. The contract provides a hedge for both the farmer and the cereal producer. A hedge is an action that decreases uncertainty or risk.
But what if the farmer cannot find someone who genuinely needs the wheat? The farmer might still find a counterparty that is willing to engage into a contract to buy the wheat in the future at a price agreed on today. This counterparty may anticipate being able to sell the wheat at a greater price in the market than the price agreed on with the farmer. This counterparty may be labeled a speculator.
This counterparty is not hedging risk but is instead taking on risk in anticipation of receiving a return. But there is no guarantee of a positive return. Even if the future price in the market is lower than the price agreed on today with the farmer, the counterparty needs to buy the wheat at the agreed-on price and later may have to sell it at a loss.
Derivatives allow corporations and investors the flexibility to manage future risks connected to raw material costs, product pricing, stock prices or indices, interest rates, exchange rates, and even uncontrollable phenomena, such as weather. They also allow investors the chance to obtain exposure to underlying assets while committing much less capital and incurring fewer transaction costs than if they had invested directly in the assets.
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