Question

What are derivatives? How can derivatives be used to reduce risk? Can derivatives be used to increase
risk? Explain

Answer 1

A derivative is a security that derives its value from an underlying asset. The asset can be equity or commodity. Some of the common derivative instruments are Futures, Options, Swaps.

A derivative is used primarily to hedge risks emanating from the underlying asset. The derivative instrument bets against the movement of security by affixing a contract with the counter party. For example, an importer who wants to bet against the chances of dollar falling in value will enter into a currency futures that could help him/her when the dollar weakens in the currency market.

While hedgers and real market entities typically try to hedge and mitigate their risks by buying the corresponding derivative instrument, there are some other set of participants called the speculators who bet on the direction of currency or stock prices or interest rates thus increasing the risks in the market. This provides more liquidity in the market and also makes the derivative market lucrative due to the risk adjusted returns of the derivative securities.