The past half a decade has seen investors demanding stable returns on their investments and decreased volatility. A rapid transition has been witnessed in the capital markets as investors are employing derivative strategies with the objective to reduce risk, improve the yield on investment and lower volatility.

Derivatives chiefly refer to financial agreements, which are employed as risk management techniques. Such agreements derive their worth based on other variables. Their worth chiefly depends on an underlying asset. This asset can either be equity, index, currency, bond or even a commodity. Forwards, Futures, Options and Swaps are all example of derivatives. Derivatives are extremely useful in enhancing the efficiencies of the market. They can also result in destruction as bankruptcy of one variable could result in cyclic loss of other variables, which may have an adverse impact on the financial system.

There are majorly two types o derivatives, classified on the basis of their trading points:

  • Over the counter derivatives
  • Exchange traded derivatives

They have been very effective as means to secure an entity against risks; but can also be used for speculation, which is not completely ethical. These instruments can provide leverage to the underlying asset, and provide an exposure to the same, in such a manner that a small positive change in the value of the asset causes much profit. In case the derivative is linked to a certain event, this creates an ‘option’.

Importance of Derivatives

Risk is an integral part of any investment. Derivatives, however, are important tools that help to mitigate the risk to a great extent. Further, derivatives are becoming extremely common in current times. At the same time, derivatives are complex instruments which need proper knowledge and information before being used. Hence, it is crucial that individuals know how derivatives function.

While derivatives save companies from market risks, they have to be chosen and handled with caution. Using such options in an unbridled manner will lead investors into a false sense of safety and they may not realise the losses that they face. When you master the art of dealing with derivatives, you can create a bright career in the financial field. Ask for advice from our experts by contacting our team of consultants today.

Assignment

1)      What is a financial futures contract?
It is one that specifies the date on which a debt instrument needs to be delivered.

2)      What is an option contract?
An options contract permits the purchaser to purchase (call option) or sell (put option) a security at a predetermined price, subject to a time limit.