Financial Derivatives & Risk
Derivatives, also known as options, are financial instruments. Their prices depend on or are arrived at by one or added underlying asset. The most widespread derivatives are ‘call’ and ‘put’ options. A call is an option for buying as asset and a put is the option of selling an asset.
Financial derivatives can be classified into these two:
OTC–Over the counter
These are the contracts traded straightaway by two parties, with no involvement of any exchange or another mediator. Agreements for such derivatives are straightaway made between the concerned parties, as in case of a company producing construction materials and lumber. Most often these are unregulated.
These contracts are traded through dedicated derivatives exchanges or exchanges. financial derivatives including futures and options fall in this category. . of the presence of numerous traders on centralized systems prevents the operators from making any manipulations. Other Kinds of Derivatives
Derivatives are of many types. Regular derivative contracts like contracts and futures are conducted via a controlled futures exchange.
Futures entail a financial agreement requiring the buyer to buy an asset like a physical product or a monetary instrument, at a specified price on a predefined future date. When you agree to purchase a futures agreement, basically, you are promising to purchase something that the seller is yet to produce and fix its cost. Whether you deal in wheat, orange juice, pork, gold or silver, when you invest in merchandise, you are trading in this market. In fact you are taking bets on the potential of the product.
A contract allowing the owner, subject to the kind of option possessed, to sell or purchase an asset at a predetermined price till a specified date. An option is traded on a controlled exchange. So the conditions of all options are formulated by the concerned exchange. The agreement is formalized in such order that original asset, date of expiry, quantity, and strike price are identified beforehand.
Hedging means measures taken by the investors to reduce their element of risk. Financial derivatives are frequently used to “hedge” an investor’s bets. On hedging an investment the investor has taken a position to balance him financially in case the value of another investment declines. For example, a person may hedge a stock by buying an option that enables him to sell that stock at an exact price. So, even when the stock loses value, he can still sell it for a predetermined price.
Like any other trading financial derivatives too leave room for speculation, which again is associated with increased risks. It works the opposite of hedging. Speculators would get hold of derivatives, connected to purchasing assets at lower prices when the futures market goes up or inversely, selling assets at higher prices when the futures are low. But if they go wrong, they are likely to lose more and hence the enhanced risk.