Posted by: admin : Category: Derivatives are tradeable securities which represent bets about the future value of something else. That something else could literally be anything but most commonly takes the form of shares or commodities. Through a derivative, one party will agree to pay another party a certain price if the value of the agreed index is at, above or below a certain level.
Derivatives could be conceptualized as an elaborate form of insurance and, indeed, they are often used by corporations as a way of protecting themselves against risk. For example, a company which used copped as a vital input in its own business processes, might be worried about the future price of copper. A high price of copper might have a catastrophic effect on the company’s business, making its products totally uncompetitive. Naturally, such as high price of copper, should it ever come about, would therefore result in an alarming drop in revenue for the company. If the company purchased derivatives which involved it receiving a large payout in the unlikely scenario that copper should ever reach stratospheric price levels, the revenue from the derivatives would, to some extent, the lost revenue through sales. Thus, the company has hedged itself against risk to some degree.