Financial markets are known to be extremely volatile. Financial instrument such as foreign currencies, equity shares and other commodities' prices fluctuate on regular basis, and create amount of risk to all the businesses that are associated with the fluctuating prices. Derivatives are used in order to reduce the risk.
A derivative instrument or a financial derivative is a financial product whose value is based on the price of another asset. The dependent assets take the name of the underlying asset, such as the future value of gold is based on the price of gold. The underlying used can be very different, shares, stock indices, fixed income securities, interest rates or even raw materials. Whereas, hedging is concern it is opening transactions in one market to compensate for the impact of commodity price risks equal but opposite position in another market. Usually hedging is carried out to the insurance risks of price changes by entering into transactions in futures markets. In addition to transactions in futures, hedging transactions may be considered, and operations with other futures instruments: forward contracts and options. Sale of an option under the rules of IFRS cannot be recognized as hedges (Belghitar et.al 2008, pp. 43).
Today, the derivatives are being used in many of the business such as electricity supply, temperature, weather forecast. As the Securities contract Act established in 1956 states that term of derivative includes
A security that is derived from debt instrument
A financial contract that derives its value from underlying assets or index of prices
Types of derivative
There are different types of derivatives that can be used;
Forward derivatives are those contracts that are obliged to make a transaction in future, set point in time. This derivative makes the parties obliged to execute the transaction except if both the parties cancel the agreement or modify it. These are traded over the counter (Ketterer et.al, 1997, pp. 42-46). Therefore the deal can be customized that suits the buyer and the seller for instance the terms can be determined in terms of expiry date, contract size, type of the asset and quality. Furthermore it has no initial cost of entering into a forward contract.
Forward agreements are those forward derivatives that are being traded over the counter (OTC). Swap is another example of Forward agreement OTC.
A futures contract is one in which there is an agreement amongst two parties that they need to buy or sell the asset at a particular point on a specific price. These contracts are unique as they previously were contracts which were standardized and exchange-traded. A contract is referred as a futures contract id forward contract is traded on a familiar exchange. The futures contract example includes interest rates, commodities, stock market indices and currencies. Futures can be utilized by either trying to hedge or to contemplate on underlying asset's price movement. An example could be of an airline, which for hedging purpose using crude oil future. The aim will be to lower risk and to ...