Are Financial Derivatives A Necessity?

We have heard so much about financial derivatives and the role it plays on the financial market. A lot of people get lost on the complex processes involved in this contract-based negotiation system. However, are financial derivatives really necessary to your business? Is it a requirement for your business or investment to survive the shaky financial situation? Could you engage in any form of business and do away with any financial derivative?

To answer these questions, let us take a look at the purposes and the features of financial derivatives to determine if it is indeed a necessity.

Financial Derivatives as a Risk Management Measure

One of the prime purposes of a financial derivative is a form of protection against risks. Entering into a financial derivative negotiation is a way to ensure you and your business and to soften the blow of inevitable risks.

An example of the application of financial derivatives as a safety or risk management strategy comes in the form of future or forward contracts. These types of contracts create an agreement between parties to sell or exchange an asset at the present rate or currency. However, the actual trade or exchange will happen at a future or later time. This ensures both parties to a supply of the asset involved regardless of interferences that might come in. Imagine for example a metal company and a construction company. They can enter into an agreement to sell the metal products to the construction company at a price that both parties will agree on. This ensures a sure income for the metal company and a steady supply of metal products for the construction company. Both parties metal company has a reduced the risk of getting no customers and the construction company has a decreased chance of running out of metal supplies.

Financial Derivatives as a Way to Earn Profit

Apart from being a risk management strategy, you can also earn profit through wise use of financial derivatives. Through this concept, you can buy an asset that you speculate to have a higher financial value in the future. The financial derivative or money you will earn through that increase in value is an application of financial derivative concepts. You are able to buy a profitable or useful asset at a lesser price. You can also apply this concept in an inverse manner. You can sell an asset for a high cost at the present when you speculate that it will depreciate in the future. In this manner, you are able to make money out of that asset for a bigger price than simply keeping it until it depreciates.

Indeed, the functions and uses of financial derivatives are plenty. Your business can survive without such financial instruments. However, your chance for success is greatly increased with such financial strategies. Businesses of whatever type will face always face risks. Any business venture is started with the aim of gaining profit in mind. Whatever your business, you can find financial derivatives as a very useful tool.