Why We Need Derivatives

Asad Dossani
"Speculators caused the financial crisis"

"Derivative contracts to blame for financial meltdown"

"Soaring commodity prices caused by excessive speculation"

Do these headlines sound familiar to you? Chances are you've heard these more than just a few times. I certainly have. For many in the media and the general public, 'derivatives' is a dirty word. Throw in the words 'speculators', and now you have villains too.

The negative attitudes toward to derivative stems in large part from misinformation. Most people don't know the social purpose of derivative contracts. Most of us understand why equity markets are important. They are useful for companies to raise capital for investment. But why are derivatives important? And why do we need them?

The main purpose of derivatives is to reduce and hedge risk. Many businesses and individuals are exposed to financial risk that they would like to get rid of. For example, an airline needs to buy fuel to power its planes. As a result, the airline is exposed to oil prices. If oil prices unexpectedly increase, the airline loses out.

How can derivative help here? An airline could purchase oil futures contracts to mitigate their risk. Effectively, they can lock in their oil price. Derivative contracts allow them to get rid of their risk.

Let's take another example. Suppose a farmer sells potatoes. They have a harvest due in 6 months time. Between now and then, the price of potatoes could fall, and hurt the farmer. What the farmer can do is use a derivative contract to lock in their price of potatoes, and get rid of their risk.

Let's consider a third example. Consider an Indian multinational corporation that earns revenues in different currencies. They need to convert their revenues into rupees, and are exposed to risk as a result. They can use a derivatives contract to lock in their exchange rate. This gets rid of the risk they face from changes in the value of the rupee.

These examples make it clear why derivatives are important. They allow users to get rid of risk. But of course, there is a flip side to this. Suppose the hedger takes a derivative position to get rid of their risk. Who takes the other side of the trade? This is where speculators and traders come in.

As traders, we take the other side of the trade. We take on the risk that hedgers want to get rid of. And we take on the risk with the expectation of making a profit. This is why traders and speculators are needed for the market to function properly. Without us, the market is not liquid, and hedgers can't reduce their risk. Just like long term investing serves a social purpose, so does trading. Trading ensures that markets are liquid.

As traders, we are out to make money. But then so are long-term investors. And so are businessmen and employees. Even savers putting their money in fixed deposits are looking to make money. Next time anyone asks you why derivatives are useful, you now have an answer.

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18 Responses to "Why We Need Derivatives"
rashmikant gandhi
24 Mar, 2015
a short & sweet article explaining derivatives ,value investing & trading and also explaining the importance of each arm .Like (1)
01 Aug, 2014
Good OneLike (1)
30 Jul, 2014
Dear Asad, I totally agree with you on social relevance of short term traders and liquidity they provide. Value investors(Equity master :-) most of the time forget this when they talk about short term trading. The problem comes when the speculators are not properly regulated they only call the shots and market trade at unfair price this could create a worldwide inflation making millions suffer. This should be controlled. Like 
30 Jul, 2014
Derivatives for the Commodities & Forex mkt is still understandable, although why do retail investors need them is questionable. But what about the Equity mkt? Why have derivatives here? Your comment is eagerly awaited Asad. Like 
Sunil Doshi
28 Jul, 2014
Dear Asad, With all respect to you,I would stand by your View,BUT your View applies to hardly 10% of derivatives Trade.Because this "Speculators" cannot make intended profit from "MNC","Farmer","Oil Companies".They need small gullible retail Investors to make Profit.90% of derivatives Contracts are entered by those who has NO deep Understanding about the Commodity,Market Psychology,or their own Psychology.They make Huge losses,which gives the ill will to This Trade. Your Effort to educate is commendable. With Regards, Like 
Kunhikannan P Giridharam Thulicherry Talap Kannur4
28 Jul, 2014
I am interested in knowing more about derivatives Thank you KkLike 
Manjunathan Bellur
27 Jul, 2014
Best example of a daily used derivative is insurance which every one of us take / use . Simple modus operandi is , We transfer our life Risk to a third party that is Insurance company for a payment of premium for a specific period . Insurance policy is derivative of our life value . Without knowing that t is a derivative , we use them . Similarly in stock derivatives , normally , market risk is transferred by the buyer to the seller for a payment of premium . Unfortunately when Barings was drowned, Derivative was blamed for its fall , instead of the rogue trader who caused it or the lack of control mangement had . . Leesson could have traded in any other market . Manjunathan Bellur bellurnm.wordpress.comLike 
26 Jul, 2014
Yes Asad, you are right. Derivative contracts are very useful. If one company is engaged in business of importing goods or say oil companies need to buy crude. They want to reduce exchange rate risk and they can buy a forward contract for the same. But why should a clerk, working in an office or a nurse or any other person who is not even remotely connected with any dollar transaction get into such trade. Today's media is luring common people into such trades saying that there is money to be made. There are people who buy and sell agri commodities forward trades but they are in this business and are called forwarding agents. Entry of common people unconnected with these trades only tends to distort demand / supply / prices and also gives opportunities for scams eg recent MCX scam.Like 
Nitin Kumar Agarwal
26 Jul, 2014
To Hedge my Postion .In options and cash market combition I gainLike 
Mahesh Prasad Sharma
25 Jul, 2014
Dear sir, Just now Iread your information on DERIVATIVES. It was interesting and I knew the concept of derivatives in proper manner.Kndly let us know how to determine entry level in derivative contracts. Mahesh Prasad Sharma 25/07/2014 Like 
25 Jul, 2014
Principle, nature and purpose of Derivatives are lucidly explained. However, it could and should have been elaborated with live examples giving some concrete transactions of derivatives actually taken place so that the matter would have been still clearer. Thanks.Like (1)
25 Jul, 2014
Taking risk : I think a person invests in stock or stock related instruments shows one is ready to take calculated risk. What makes one nervous is either book the profit or reduce the loss. That makes one loose good night' s sleep.Like 
25 Jul, 2014
very well said but there should be some way to limit greed .oné shouldmake profit but not profit with greed .this apple equally topolitician community also.india will be great country if both business n politician community understand n kompliment this.Like 
25 Jul, 2014
Thank you very much for making the complex phenomina so simple. It is really very strange to understand how come buyer and seller can have contrary view for single event?Like 
Sundaravaradan S
25 Jul, 2014
Hi, Good Explanation of YOUR side of the views! What is the solution to have a BALANCED & Matured Derivatives market? How to minimize/avoid GREEDY Speculators? Like 
25 Jul, 2014
You explained it clearly. Thank you Like 
25 Jul, 2014
Very simple and knowledgeable information Thanks!Like 
25 Jul, 2014
TA very interesting and informative take on Derivatives!!Like 
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