A Closer Look At Financial Derivatives
The issue of financial derivatives has been a focus of discussion nowadays. These financial instruments have been associated with the declining condition of our financial market. To fully understand the impact of the use or misuse of financial derivatives, let us look into its definition, history and purpose.
Defining Financial Derivatives
A financial derivative is essentially a financial instrument that gets or derives its value out of an agreed upon contract. The value of a financial derivative comes from the value of a certain asset. This value fluctuates according to the movements of the financial market. It has been primarily used as a risk management venture through various financial measures.
History of Financial Derivatives
The use of financial derivatives dates back to a time when there was no formal financial market yet. The principles of financial derivatives have been operating in simple trade and merchant operations for a long time now. A simple application can be seen between the contract of a wheat farmer and a miller. The wheat farmer and miller enter into an agreement to sell wheat at an agreed price even before harvest season comes. This ensures the farmer a return of cash and the miller a steady supply of wheat. However, both parties also create a risk situation out of the agreement. The wheat farmer is bound by the agreement to sell his harvest to the miller at the agreed price. This could back fire on the farmer if the price of wheat rise above the agreed upon rate on the day of harvest. The farmer loses out on the profit he could have gained out of that increase in wheat price. On the other hand, the miller also assumes certain risks. The miller agrees on buying wheat from the farmer at a certain price and may lose money if the price of wheat goes down. Hence, there is an inevitable risk-profit relationship created in this type of contract. The farmer and miller each derive a financial value on the outcome of the harvest and the wheat's price on the future date of trade.
What is the purpose of these financial instruments?
The creation of the financial market and complex systems of financial transactions gave way to a new application of financial derivative concepts. Now, the term applies to complex financial trading on various assets and investments.
The main purpose of financial derivatives lies on its role as a risk management strategy. Through a financial derivative, one can be ensured against potential risks. An example of which happens in a trader who would not want to lose profit on exporting his products. He may enter into a contract with a buyer who will agree to buy his products regardless of the change in currency when sold in another country.
Financial derivatives are risk management strategies that serves a good purpose. However, unwise use of this strategy could back fire and make you lose a lot of money on financial transactions.
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