Derivatives: Overview, definition, and example
What are derivatives?
Derivatives are financial contracts whose value is derived from the performance of an underlying asset, index, or benchmark. Common types of derivatives include futures, options, swaps, and forwards. The value of a derivative is based on the price of the underlying asset, which can be anything from stocks and commodities to currencies and interest rates. Derivatives are primarily used for hedging risk, speculating on price movements, or increasing leverage in financial transactions.
For example, a futures contract is a derivative that allows the buyer to agree to purchase an asset at a predetermined price at a future date, based on the expectation that the asset's price will rise by that time.
Why are derivatives important?
Derivatives are important because they provide market participants with tools for managing risk and gaining exposure to price movements of underlying assets without owning them directly. They are widely used by businesses, investors, and financial institutions to hedge against price fluctuations, such as fluctuations in commodity prices, interest rates, or stock prices. They can also be used for speculation to profit from predicted price movements.
For businesses and investors, derivatives are useful for protecting against adverse price movements or for taking on risk in a controlled manner to enhance returns. However, they also carry significant risk, as incorrect predictions or market shifts can lead to substantial losses.
Understanding derivatives through an example
Imagine a company that exports coffee beans to foreign markets. The company is concerned that the price of coffee beans will decrease, so it enters into a futures contract with a financial institution. The contract locks in a price for the coffee beans they will sell in six months. If the price of coffee beans falls in the market, the company is protected, as it will still sell the beans at the agreed-upon price. However, if the price of coffee beans rises, the company misses out on potential higher profits but still benefits from the price stability the derivative provides.
In another example, an investor who believes that the price of oil will rise may buy oil futures contracts, agreeing to purchase oil at today's price for delivery in three months. If the price of oil does rise, the investor can sell the futures contract at a profit.
An example of a derivatives clause
Here’s how a clause like this might appear in a contract:
“The Parties agree to enter into a derivative contract in which the value of the contract will be tied to the price of [Underlying Asset], with terms specified for settlement and risk management as outlined in the attached agreement.”
Conclusion
Derivatives are financial tools used to manage risk, speculate on price movements, and increase financial leverage. By deriving their value from underlying assets, they offer flexibility and opportunities for hedging against uncertainty in markets. However, because they involve speculation and leverage, derivatives carry substantial risk and should be used with careful consideration and expertise. Understanding how derivatives work is essential for anyone involved in financial markets or transactions involving risk management.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.