Derivatives Market

The derivatives market has been one of the fastest growing in the world. Just a few decades ago the derivatives market was very small, this has changed dramatically in recent years. Now there is more money traded on derivatives than on stocks. This has a number of people concerned as there are some concerns about the widespread use of derivatives.

Derivatives are basically futures and options; there value is derived from the underlying asset. The underlying asset can be almost anything that has value. This can include stocks, commodities, bonds and currencies. The reason that derivatives are usually traded rather than the underlying asset is that they allow for the transfer of risk. People who don’t want to take risks can use derivatives to reduce their risk by allowing people who are willing to take the risk to receive extra profit for doing so. In the last couple of years of derivatives have gotten a bit of a bad reputation. The problem is that they tend to encourage too much risk taking. They also tend to reduce the productive use of capital. When you buy stocks you are helping a business to grow, when you buy the options on the stock you are really doing nothing to help the business but are simply betting on what the stock will do.

Futures are the simpler of the derivative options, the allow you to buy or sell the underlying asset at a predetermined price. In the simplest approach you would buy a futures contract in the hopes that the price of the asset will go up before you have to take delivery. If this happens you will be able to sell the asset for more than you paid for it. Over course the person who sold it to you will be hoping for the opposite. If the price goes down he will be able to deliver the asset to you for a lower price than you paid him for it. The main use of futures is to allow companies to get set prices on the materials that they use. For example if they need oil to run their business they could buy futures contracts, this way they will know how much they are going to have to spend on oil beforehand so they can plan out their budget.

Options are a much more complicated derivative than futures. An option gives you the right to buy or sell the underlying asset at a certain price by a certain date. The main difference here is that you don’t have to buy or sell the asset if you own the option. For example if you bought a futures contract you are obligated to take delivery on the agreed upon date. With an option if the price has declined to a level that you would lose money you don’t have to take delivery. Of course you have to pay a premium for this flexibility.