In this paper, different concepts of derivatives have been discussed like forward contract, future contracts, swaps, and options. The role of derivatives for corporations and institutional investors has been also discussed. The difference between hedging and speculation has been also addressed in this paper. The paper also talks about the ways corporations and institutional investors use different derivative contracts to hedge the underlying risk. The effective use of derivative results in to effective hedging of the risk. At the end of the paper, Hedge funds have also discussed in order to highlight the point that hedge funds are not risk free instead these funds target riskier and less diversified investments.
It is a kind of financial Security whose price is derived from or dependent upon one or more underlying assets. The derivative itself is simply a contract between two or more parties. Its value is determined by variations in the underlying asset. Some common underlying assets include stocks, bonds, commodities, currencies and interest rates. Derivatives are mostly characterized by high leverage. Forward contracts, Future contracts, swaps and options are the most common types of derivatives (Harper, 2009).
Derivatives are generally used as a mechanism to hedge risk, but can also be used for speculative purposes. For example, an American investor buying shares of a European company of a European exchange (using Euros to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could buy currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into US Dollars.