What are Financial Derivatives
First let us understand what you mean by derivative. It’s a simple agreement between two or more parties to pay a certain amount agreed upon at the time of a contract. In financial terms it is value that is derived from an underlying asset such as stocks, bonds, currencies and market indecies.Derivatives are generally used as an instrument against risk. For example an investor of Indian origin purchasing shares of some other country will have to face the risk of exchange rate. To evade this risk the investor can buy currency futures to latch the specified exchange rate for future stock sale.
Financial derivatives have changed the finance world by creating novel ways of understanding, measure and manage risks. So we recommend that these financial derivatives be a part of an organization’s risk management strategies to guarantee that value enhancing investments are done. In today’s economy as well financial derivatives has found an important place.
After understanding the above metrics, now let us why we should have derivatives. These are risk shifting devices used to reduce exposure to changes in stock markets. For example if an European country wants its payment for shipment of goods in euros, it can enter into an agreement with that country to reduce the risk of exchange rates which might become unfavorable at the time of billing. So under the derivative agreement the other party is bound to pay that company the amount due on that date as per the exchange rate in effect when the derivative contract was entered no matter the variations in the rates of exchange.
Not withstanding these risks there are a few myths which we can familiarize for better understanding of financial derivatives.
Derivatives are new, complex and high end financial products.
Derivatives are highly speculative.
Because of its size derivatives trading are unsafe and unsound financial practices.
Only large multinationals and big banking firms have use of these derivatives.
Financial derivatives are the latest risk management trend.
Derivatives take money out of productive processes and never put them back.
Only risk seeing firms should use derivatives.
The risk linked with these derivatives is new and unknown.
They link market participants tightly, thereby increasing risks.
Now the organizations think should they use derivatives? Yes they should, derivatives allow a smooth transfer financial risks which help to ensure value enhancing opportunities. If these derivatives are used properly it reduces risks and increase returns. Derivatives also have a gloomy side. It is important for the derivative players to understand them properly. They should the complexity of financial derivatives contracts and use them appropriately to cover risks.