Derivatives are legal contracts that set the terms of a transaction that can be bought and sold as the current market price varies against the terms in the contract. Originally, derivatives were all about bringing price stability to products that can be quite volatile in their pricing over short periods of time.
Prices change quite a lot over time, which adds a degree of uncertainty and risk for those who either produce or purchase large quantities of goods.
Say, for example, that a producer of candy corn anticipates producing 10 tons of the candy but is afraid that prices will go down before it produces and sells it all, putting the producer at risk of earning lower profits or even losing money on the sale, since the producer is incurring overall prices as it produces the candy corn.
The producer calls its derivatives agent, who then puts together whichever type of derivatives contract the producer wants and attempts to find a buyer who will purchase the candy corn at a later date, using the terms of the derivatives contract.
On the flip side, say that a buyer of candy corn knows it wants to purchase 10 tons of the candy about four weeks before Halloween but is afraid prices will increase by then. The buyer can also call an agent to create a derivatives contract for the purchase of candy corn.
By speculating on the changes in future prices, companies have the opportunity to buy and sell many derivatives contracts at a profit simply because of other people’s willingness to trade these contracts. As a result, derivatives have dramatically increased in popularity as a method of generating income.
They can be purchased and then resold at a profit; however, the whole process involves a great deal of risk of multiple types. Although derivatives have fallen under attack in recent years, when used responsibly, they can provide companies with a useful financial tool.
The four most common types of derivatives are
Options
Forwards
Futures
Swaps