Different countries have different national currencies which have different values at different period of time. To trade internationally there had to be a system how all these things can be accounted for all these differences.
A derivative is a contract that is used to safeguard or protect impartially the fluctuating exchange rates of goods that are traded internationally. In other words, it is a “security of the price” that is derived from underlying assets between two or more parties. This contract based upon the assets. Underlying assets can be bonds, stocks, currencies, commodities, interest rates, and market indexes.
There are many kinds of derivatives in existence. Depending upon the type, they are a variety of functions and applications.
Lets us understand this with an example. Let us say a farmer (one party) in July (during sowing season) agrees (contract agreement) to sell 1 metric ton of rice (underlying asset commodity) in October (after harvesting season) to a miller (second party) for Rs.32,000/- (price consideration) per metric ton. Current price being Rs.35,000/- per metric ton. Now if by October per metric ton of rice costs Rs. 33,000/- Still the farmer will have to sell at Rs 32,000/- per metric ton. In this case, the farmer was at loss of Rs 1000/- and miller is at a profit of Rs 1000/-. What if October price were Rs. 31,000/- in that case farmer would have made profit and miller would have made a loss by Rs 1000/-.
From the above example, we can conclude that whatever will be the price in open market farmer will get Rs 32,000/- per metric ton and miller too knew that he will buy rice for Rs 32,000/- irrespective of market condition. Both knew their rates in July itself.
Certain types of derivatives are used for hedging against risk on the asset. They can be also used for speculation on the future price of underlying asset.
How can you use derivatives? Futures and options are standardized contracts and can be freely traded on exchanges.
One can earn money on stocks which are kept ideal for too long. The advantage of price fluctuation can be taken in this case. Derivative markets allow you to conduct transactions. No need to sell shares physically.
Taking advantage of the difference in prices in different exchanges is called arbitrage. Benefitting by purchasing low from one exchange and selling at high in another exchange.
- Protecting securities
One can protect his securities against fluctuating prices. That is you can hedge your securities against falling market by the products that are offered in derivative markets. They also protect you from the rise in prices if you are purchasing securities.
- Risk transfer
This is one of the most important uses of the derivative market. It transfers market risk from non-risk taking investor to risk taking investor. Non-risk taking investors use derivatives to increase their safety, whereas risk taking investor conducts risky business to improve his profit. There are many strategies and products available that help in transferring risk both ways.
Derivative participants, types of derivative contracts, trading in derivative market in another blog.