Kenneth R. Szulczyk
Derivatives are contracts, and buyers and sellers exchange the contracts in the derivative
markets. They do not trade assets. Common derivatives are futures, forwards, options, Credit
Default Swaps, and currency swaps.
Investors use two strategies to invest in the financial markets: Speculation and hedging.
Some investors use speculation when they buy or sell securities because they believe they can
sell the securities for a higher price in the future. Speculators search for quick profits and are
gamblers. As you guessed, a speculator can gain or lose massive amounts of money from the
derivatives market. Speculators are vital to the market because their presence increases the
liquidity of the securities.
Investors use hedging to buy and sell securities to reduce risk or use long-term investment
strategies. Hedger protects himself in three ways by using derivatives. First, he locks in a future
price today, protecting himself from price fluctuations. Second, derivatives are liquid assets. If
an investor needs money now, he easily can sell his futures contract in a derivatives market.
Finally, investors buy and sell derivative on organized exchanges, and they can monitor and
gather information on market prices of derivatives.
Hedgers use financial derivatives for the following three cases:
Case 1: Hedger uses a financial derivative to reduce price uncertainty because a derivative
locks in a future price today.
Case 2: Hedger could reduce the interest-rate risk. If a banker knows he or she will grant a
loan on a specific date in the future, subsequently, he or she can buy a derivative that locks in
the future interest rate. Interest rate becomes the price on the financial derivative. Thus, the
banker borrows at a low interest rate and lends at a high interest rate.
Case 3: Hedger could reduce the exchange rate risk. Currency exchange rate is the price in
a currency derivative. For example, a corporation operates in a foreign country. If that country's
currency depreciates, then a corporation could experience gains or losses in profits from that
country.
Futures and Forward Contracts
First class of derivatives is futures and forward contracts. They specify size, maturity date,
and price. Size indicates the number of units in each contract, while the maturity date is the day
the parties complete the transaction. Finally, the futures price is the selling price of the asset on
the maturity date. However, futures differ from forwards. A forward contract is tailor made that
banks or dealers issue. Issuer’s reputation and collateral guarantee the contract. On the other
hand, a futures contract is standardized. Maturity, size, and collateral are the same for all
contracts. Standardized contracts allow investors to buy and sell futures contracts on organized
exchanges. For example, the Chicago Board of Trade allows futures for agricultural products
and precious metals, while the New York Mercantile Exchange allows the exchange for energy
commodities like petroleum and electricity.
Futures and forward contracts allow the buyer and seller to agree on a price for a
commodity today, and the exchange of money for the commodity will occur on a specific date in
the future. For example, you buy a government bond one year from now. You could enter a
futures contract where you and the seller agree on the price today, but you pay for the