Since the 1970's, the trade of derivative securities has over expanded and has characterised most of the transactions in the world financial marketplaces. However, derivatives do not constitute a new notion in the financial world, since they first appeared in the 17th century, with the trade of commodities. Hence, cultivators, to hedge risks -that means to protect themselves from variations between the sale price and the delivery price- looked for a solution, a contract that would guarantee them a minimum price, so that they can still make profit. Derivatives securities are instruments whose values are derived from the values of other relates securities. There are various types of derivatives but the two most popular ones are financial options and futures. The former can be defined as a "contract that gives its holder the right to purchase (call option) or sell (put option) a specified asset under specified conditions".
[...] To conclude, one can say that derivatives such as futures and options are very efficient and useful instruments in the financial markets. Indeed, by the system of hedging, one can reduce risk and maintain a certain stability vis-à-vis the variations of prices, exchanges rates or interest rates Yet the complexity of derivative trading is huge and a good understanding of the different mechanisms is required to maximise profit and to avoid market crisis. However, in recent years, individual company losses through derivatives have become almost “routine”. One justification for the phenomenon is about speculation which can lead to very unstable situations. [...]
[...] This will only occur if the stock price is inferior to At a price between and the investor will exercise the call option but will incur a loss equivalent difference with the premium. Thus, it's only at a price superior to that the investor will break even. Similarly; in a put options contract, with the same conditions, the investors would only make profits if the price of the underlying asset were inferior to the premium. Thus with this mechanism, options can be used either to reduce risk (hedging) or to increase risk (speculating). [...]
[...] default risk and hence make futures more tradable as well, futures exchanges make use of clearing house which covers any default arising from a contract. Thus, buyers and sellers only have obligations towards the clearing house and the only default risk faced by someone entering a future contracts are due to problems with the creditworthiness of the clearing house itself. In addition to the clearinghouse, there are other safeguards for the futures markets such are requirement for margin and daily settlement. [...]
[...] If the stock price decline over this period, the index will decline as well, and so will the futures contract on the index. The mutual funds will gain on its futures position, because the price it paid for the index at the settlement date will be less than the future price at which it sold the index. Yet this system only works if there is no error with the correlation between the portfolio and the index. We can envisage many other different scenarios of hedging risks with futures. [...]
[...] Consequently the company benefits from the futures contract and escapes the higher price. However if the price of cotton had decreased, the company would have been better without entering the futures contract. Yet since the cotton market is volatile, the company was still protecting itself from risk by entering into the futures contract Hedgers can be opposed to speculators in a sense that the formers are more likely to make profit by minimizing the risk, whereas the latter rather benefit from the inherently risky nature of the futures markets. [...]
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