Derivatives are contracts between two and more parties whose value is defined in a financial asset or portfolio of assets, typically including debt, mass commodities, currencies, interest rates, market indices and stocks, among others.

Futures contracts, forward contracts, options, swaps, warrants, etc. are very common derivatives and these derivatives are affected by the performance of the contract because of their value, which is similar to a stock option, which is also a derivative because its value is derived from the value of the stock.

Although the value of the derivative is derived from the asset as a basis, the derivative does not own the asset, it just owns the contract sheet. Derivatives belong to the advanced or technical area of investment and are used for speculative and hedging purposes.

Take a simple example of a farmer and a middleman.

The farmer believes that the onset of the rainy season will affect the yield of harvested vegetables, causing the farmer's earnings to be affected, so the farmer is the one who approaches the owner of the middleman to sign a three-month contract, the content of which is that the middleman must buy all the vegetables at $10 for the next three months. The middleman enters into the contract to secure the supply of the commodity, and although both parties reduce the risk by hedging, they are still exposed to the risk of price changes.

The farmer is guaranteed the value of the price contract, but the price may go up, for example, if the weather is fine and the farmer has a very good crop, but will end up losing the extra income he could have received. Similarly, the price of the commodity may go down and the middleman will have to pay above market prices for the commodity.

This is where the use of futures contracts as a hedge allows farmers to focus more on running their vegetables and worry less about price fluctuations, while the middlemen are able to protect the supply of the commodity.

• by Andrea
• Aug 11,2021
• Topics
• 393

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