As its name suggests, a derivative derives its actual value from its underlying asset. It is a financial contract in which the buyer agrees of purchasing the asset over a specific price at a specific time.
Most of the time, derivatives trading are used in transactions involving commodities like gold, oil, and gasoline.
Another asset in which derivatives are actively used is for currencies particularly the U.S dollar. Moreover, derivatives also appear on bonds and stocks.
Just in 2017, there were 25 billion derivative contracts traded. Because the interest rates are high, the trading activity for options and futures greatly increased in Europe and North America.
As for the Asian countries, there was a decline because of the decrease in commodity for products from China. The contract was worth $532 trillion.
The world’s largest companies utilize derivatives to lower the risk associated with trading. For instance, a futures contract agrees to deliver raw materials at a specific price.
This is the way of the company to protect the rise of prices. Furthermore, companies also found a way to protect themselves against vast changes in exchange rates as well as interest rates by writing contracts.
Uses of Derivatives
If you want to make the future cash flows more foreseeable, derivatives offer good help. Companies are able to tell their earnings more precisely and that kind of predictability helps boost the stock prices.
In turn, businesses are needing less cash to help cover emergencies then, they can reinvest in other important investments.
Most of the time, derivatives are being used on hedge funds and other similar investors to be able to achieve greater leverage. Since derivatives only need a small initial payment or paying on margin, it is mostly favored by investors.
There are a lot of derivative contracts that are liquidated against other derivatives before it comes to terms. Such traders don’t have to mind having a lot of money to pay for their derivatives in case the market goes against the prediction. And naturally, if they win, they can simply cash in.
Over-the-counter options for derivatives trading are those transactions made between two different companies or investors that are personally acquainted with each other. An intermediary of a large bank is also an option.
Only a small percentage of derivatives throughout the world are being traded through exchanges. These exchanges have standardized contract terms.
Within the contract, they have specified the discounts and premiums that the investor will shoulder. Because of this standardization, the liquidity of derivatives is greatly improved.
They become more exchangeable, therefore, helps them become more beneficial for hedging.
Exchanges also serve as a clearinghouse. They act as the actual seller or buyer of the derivative. Because of that, traders feel more secure, thinking that the contract will surely get fulfilled.
Currently, the largest exchange group is held by the CME Group. This group was developed after Chicago Mercantile Exchange and the Chicago Board of Trade merged.
They are either called CME or Merc. They are trading derivatives in all forms of assets.