Derivatives are used as a means of providing protection against the uncertainty of the prices of asset or asset groups. Derivatives are contracts between two or more parties based on the price movements of the underlying asset. The price of the derivative depends on the price fluctuations of the underlying asset. Here the underlying asset can be a stock, bond, commodity, market indices or interest rates. Derivatives can also be traded on the stock exchanges or over-the-counter (OTC). A major portion of these instruments is OTC as they are not regulated.
Origin and Uses
The early forms of derivatives were used to ensure stable exchange rates in international trades. The frequent changes in currency rates made accounting difficult for the international traders. This system was a way to record the differences from the currency rate fluctuations. Today these instruments have grown both in number and the level of complexity. The best part of these instruments is that one can design a derivative for any type of situation. There are derivatives on the amount of rain or sunny days in a particular place. In today’s financial market, derivatives have a great share as the risk factor in the industry is always increasing. Derivatives are most commonly used to hedge the risk or act as an insurance against specific risks on the assets.
Role of derivatives in the financial market
Derivatives are not to be viewed as mere tools to hedge against the risk of price fluctuations in an asset; rather it is a system which allows a large number of investors makes a profit without any direct ownership or entitlement of the underlying asset. Thus by spreading the risk over this type of instruments provides a boost to the investment activity in an economy. It is important to note that derivatives do not reduce the risk rather it spreads or distributes the risk. The Derivatives exist in the market due to the volatile nature of the market. This volatility is what promotes speculative trading and derivatives provide the required hedging against these speculative risks.
Derivatives – customized based on the underlying asset
These instruments can be customized based on the different underlying assets. The most common ones are currency forwards, futures, Swaps, Options etc. There are derivatives on mortgages as well.
Derivatives from being mere tools of risk management have grown to become an indispensable part of the financial system. Cryptocurrencies are also becoming a crucial part of our financial system with some of the exchanges offering trade and conversion of these digital assets. Bitcoin code is a major online trading platform, read this review for which offers excellent trading opportunities to its users.