Derivatives Case Study

Derivative Futures and Financial Engineering Throughout financial markets worldwide the use of derivatives as a risk management methods have increased substantially over the last few decades. Derivatives are considered a financial instrument that derive their value from another financial asset or variable and as such they contrast from more commonly known financial instruments such as stocks and bonds. The main goal of derivatives is to protect investors against risk by allowing them to hedge their risk in the future value of an underlying asset (Derivative, 2016). This can be accomplished through different derivative forms, including swaps, options, forwards and futures. Forwards and futures are legally binding agreements used by investors
During this era, farmers would grow and sell their harvest to customers in the marketplace. Unfortunately, with little information about the demand of their agriculture, many farmers would leave the market place with either a surplus supply or not enough. In order to combat this demand spread, farmers began dealing their commodities for either immediate delivery or future delivery, known today as the spot or future price. Additionally, historic futures were used by farmers and consumer to combat out of season crop prices, by allowing the two parties to enter into a contract at which the consumer would pay the farmer an agreed upon price for their agriculture at a future date. As future contract use expanded, supply and demand stabilized, yearly agriculture costs leveled, and farmers were able to prevent crop loss (Heakal, n.d.). While, the underlying concept of futures has remained consistent since their inception, the application of Futures have broadened in
Since futures derive their value from a financial asset they can be used by investors to gain exposure to other financial instruments such as, indexes, stocks, commodities and currencies. This makes them a powerful tool in hedging risk because the “futures market attempts to lower transaction costs and generate liquidity. An exchange facilitates trade by removing uncertainty about the reliability of the other side of the trade, and by developing a standardized contract, so that a large enough group of interested traders will exist so that positions can be offset without large price disruptions” (Carlton, 1984, p. 239). Therefore, transactions within a futures market provide a network in which investors can offset price disruptions, effectively hedging