Derivatives arenot products, they are securities in which they are linked to another security,such as stocks or bonds. A derivatives value is based on thesecurity they are related to, and they are therefore worth nothing by themselves. The buyer agrees topurchase the asset on a fixed date at a specific price knowing that thecontract’s seller doesn’t have to own the underlying asset.
Instead, he canachieve the contract by giving the buyer enough money to buy the asset at the ultimateprice. Not only but also the contract’s seller can give the buyer anotherderivative contract that offsets the value of the first. This resultsin making derivatives much easier to trade than the asset itself. Derivativeshave features that allow them to be used as hedging tools, hence reducing therisk faced by organizations and individuals.A report prepared by the statisticsdepartment in International Monetary Fund defines derivatives as financialinstruments in which they are linked to a specific financial instrument, indicatoror commodity.
Through which specific financial risks can be traded in financialmarkets in their own right. The author added that transactions in financialderivatives should be treated as separate transactions rather than as essentialparts of the value of underlying transactions to which they may be linked. Thevalue of a financial derivative arises from the price of an underlying item, forexample an asset or index. The author differentiate between financialderivatives and debt instruments, were in derivatives no major amount isadvanced to be repaid and no investment income accumulates. The report also addressedthat financial derivatives works for risk management, hedging, arbitrage, andspeculation.
A recent study shows that: “In 2016,25 billion derivative contracts were traded. Asia commanded 36 percent ofthe volume, while North America traded 34 percent. Twenty percent of thecontracts were traded in Europe. These contracts were worth $570 trillion in2016. That’s six times more than the economic output of the world.” Moreoverthe study also added that “More than 90 percent of the world’s 500 largestcompanies use derivatives to lower risk”. Financial derivatives are securitieslinked to another security, derivative’s value is derived from the value of theunderlying asset.
A transaction is present when both parties the buyer and theseller write a contract, in which fixed date at a specific price is agreed inadvance. Trading derivative is easier than trading the asset itself, derivativesare used as hedging tools, therefore reducing the risk faced by organizationsand individuals. Companies also transcribe contracts to protect themselves fromchanges in exchange rates and interest rates. Derivatives are traded worldwide,they are traded in special markets, and buy different traders. This will befurther introduced in the parts below.