Apart from stocks, bonds, and commodities, there are still many other financial instruments that you can use to earn some money out of the financial markets. And one of them is the so-called derivative. What is a derivative? And what benefits can be gotten from it?
What are derivatives?
Derivatives derive their value from the value of some other financial asset or variable. For instance, a stock option contract derivative derives its value from the value of a stock. An interest rate swap is also a derivative since it derives its value from an interest rate index.
The asset from which the derivative derives its value is referred to as the underlying asset. And since a derivative’s price depends on the underlying asset, the price will also move up or down based on the asset’s movements.
Purposes and Benefits of Derivatives
Future market prices depend on a continuous flow of information from the world. They also require a high degree of transparency.
They are also affected by a broad range of factors like climatic conditions, political situations, debt default, refugee displacement, land reclamation, et cetera). That’s because those things also affect the law of supply and demand.
This type of information and the way people absorb them changes the price of a commodity, and the process in which this happens is called price discovery.
With some futures markets, the underlying assets can be geographically dispersed and can have many spot or current prices in existence. The price of the contract with the shorted time of expiry often gets chosen as a proxy for the underlying asset.
Further, the price of all future contracts serve as prices that can be used and accepted by Trade Spot Gold and Silver traders of the contracts in lieu of facing the risk of doubtful future prices.
Options can also help in price discovery, though not in absolute price terms. They can help in the way the market participants view the volatility of the markets. This is due to options’ differing form from hedging. Options enable traders to protect themselves against losses while letting them take part in the asset’s gains Deposit and Withdrawals.
Arguably the most important purpose of derivatives is risk management, which is the process of identifying the desired level of risk, identifying the actual level of risk, and changing this actual level to match the desired level.
Hedging has conventionally been defined as a tactic for minimizing the risk in holding a market position. Meanwhile, speculation has been defined as taking a position in the way the markets will move. Nowadays, hedging, speculation, and derivatives are used together to help corporations manage their risks better.
Improving Market Efficiency for the Underlying Asset
To illustrate, an investor who wants to be exposed to the S&P 500 can purchase an S&P 500 stock index fund or copy the fund by buying S&P 500 futures and investing in risk-free bonds. Either of these two ways can give him or her exposure to the index without having to purchase all the underlying assets in the S&P 500.