A financial derivative is a tool which derives its value from an underlying asset, where the asset can be anything that exists as a tradable entity .
This value is derived on the future expectation of the asset price movement to be experienced by the investors involved in the transaction of the particular asset.
This introduces a risk associated with the asset price movement.
This risk is calibrated in the form of price differentials and the observed value of a derivative derives itself from the expected future price of the asset.
Risk as an opportunity is used in the form of future expectation that creates a value of the derivative representing the risk.
The uncertainty of the future is quantified as a value that signifies the change in the price of an asset that is expected by the investor.
This process uses derivatives to protect profitability against price movements. It is a very interesting phenomenon that uncertain futures are put into values that can be traded on the secondary markets with a convergence of interest on the expected value on a future date.
This transforms risk into opportunities of generating profits by trading derivatives with a view on future expectations. But risk will always remain a risk as it cannot be reduced to any other form.
Derivatives, as risk management tools, can only spread or distribute the risk of price movements rather than reducing any risk that is associated with the future change in price of the underlying asset.
Hence, derivatives cannot be said to control risk but spread risk so that producers or consumers have the opportunity to secure their profits against possible negative price movements.
This poses the essential question that if derivatives secure profits of the producers and consumers than who bears the cost of a price change?
On the other side of a derivative transaction is the ‗speculator‘. Speculators bet money on the price change in the opposite direction as the producer or the consumer they are transacting with .
Therefore, speculators are looking to generate profit against a possible price movement. This is the ideological divide on the use of derivatives.
With the definition of this financial innovation in the form of derivatives, they are profit securing tools that can be exercised by producers or consumers to secure profits.
