6) Derivatives

Question 1

What is a derivative?

Answer 1

• a financial instrument whose price is based on the price of something else, typically an underlying asset - such as: a bond, share or commodity

Question 2

What are the different types of derivatives?

Answer 2

• forwards - these priced a stated amount of goods between a buyer and a seller
• futures -
• options

Question 3

What are the two purposes for which derivatives are used?

Answer 3

• hedging
• speculation

Question 4

What is hedging?

Answer 4

• hedging involves replacing uncertainty with certainty so that the risk is reduced
• if a price is agreed in advance then they can plan with certainty and don’t need to worry about how market prices will change
• both parties use the derivative - the forward contract - to ‘hedge’ the risks they face by replacing an certain price with a certain one

Question 5

What is speculation?

Answer 5

• using derivatives to make money => by correctly anticipating that the price of a commodity and then being able to sell it anf generate a higher profit without having to store and insure it completely
• they could use a derivative contract to commit to buying the grain at an agreed future date at a pre-agreed price. If the price increases, then it could be sold onwards for profits asap, physically with them or not

Question 6

What happens if the speculator is incorrect and the price of the commodity falls?

Answer 6

• without derivatives -