Derivatives

In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked—called the underlying— such as a share or a currency. Derivatives are tools for transferring risk.

Hedge is making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

Futures, options and other derivatives exist in order that companies and individuals may attempt to diminish the effects of, or profit from, future changes in commodity and asset prices, exchange rates, interest rates, and so on. For example, the prices of foodstuffs such as wheat, maize, cocoa, coffee, tea and orange juice are frequently affected by droughts, floods and other extreme weather conditions. Consequently, many producers and buyers of raw materials want to hedge, in order to guarantee next sessions prices. When commodity price are expected to rise, future prices are obviously higher than (at a premium on) spot prices, when they are expected to fall they are at a discount on spot prices.

In recent years, especially since financial deregulation, exchange rates and interest rates have also fluctuated wildly. Many businesses, therefore, want to buy or sell currencies at a guaranteed future price. Speculators, anticipating currency appreciations or depreciations, or interest rate movements, are also active in currency future markets, such as the London International Financial Future Exchange (LIFFE, pronounced ‘life’).

(There are many kinds of derivatives, with the most common being futures, options and swaps.)