Understanding Derivatives and Futures

The notion of a premium is the key to understanding derivatives. It is like paying a premium to an insurance company to obtain some protection. There are also derivative products that incur payoff contingent upon the occurrence of some event that you need to be paid in advance.

As an alternative to buying shares in the cash market, you could buy a 1 month call option stock of a company with a strike price of $50 and this gives the investor a right though not the obligation to purchase company stock at $50 in a month’s time. Instead of instantly paying $5,000 to receive the stock, it may take $700 to pay this right today. If the company stock increases to $75 in a month’s time, an investor can exercise the option to both buy the stock at the strike price and sell in open market, garnering a net profit of $1,800.

Market-to-market accounting is a manner of revaluing an inventory of financial products at a pre-set interval (generally during the end-of-business every day) at current market rates. The combined realized and unrealized profit and loss is listed to the profit-and-loss account. A good practice in managing any financial portfolio is mark-to-market accounting.

Futures markets on the other hand aim to enable hedgers to shift price risk – volatility of asset price – to speculators in exchange for basic risk – shift of difference between the cash and futures price or the underlying asset and the current spot price. In the financial community, hedging is viewed as a form of risk management and speculating as a form of taking risk.