Financial Derivatives: Good Or Bad?

A lot of people have different opinions and views on financial derivatives. The views range from financial derivatives as useful instruments to being unnecessary waste of time, effort and money. Are financial derivatives really useful or not? Are these financial tools inherently good or bad?

The up side of Financial Derivatives

There are many advantages to these financial strategies. The use of financial derivatives can serve as a risk reduction tool. Through financial derivatives, one can be ensured against potential risks. A business owner or investor then enters into a transaction with another party in order to decrease the impact of potential risks that might occur. Wise business owners will use this feature of financial derivative to reduce risks and increase profits.

Another advantage of financial derivatives is the chance to let you earn more profits. Through a contract, the owner can choose to buy or sell products in a manner that earns him more profit. The concepts of financial derivative also give you the freedom to buy assets at a low cost or sell them at a higher price.

The Down Side to Financial Derivatives

Like a coin that has two sides, financial derivatives also have their down side. A disadvantage of financial derivative is the possibility that it can make you lose money. While financial derivatives help increase profits and reduce risks, it may also make you lose out on a lot of money or other assets. Imagine this situation for example. A cotton farmer enters into a contract with a weaver. Both of the parties need the cotton as a resource to continue in their business. Thus, they can enter into a contract to benefit them. The cotton producer may agree on a fixed price to sell the cotton to the weaver on harvest time. This ensures a fixed income and a sure customer for the cotton farmer. On the other hand, the weaver is also ensured of a supply of cotton. This agreement could be a disadvantage when the price of cotton fluctuates. If the price of cotton goes up, the farmer would still have to sell the cotton at the earlier agreed cost. This makes the farmer lose out on the profit. Price fluctuations on the cotton could affect the weaver too. If the price of cotton goes down, he still has to pay the high cost that was agreed in the contract, regardless of the decrease in cotton's price or value.

Now that you know the up side and down side to financial derivatives, you are in a better position to know if it is good for you. The use of financial derivatives is never inherently bad or good. It all depends on how you use it and how well you execute the activities associated with financial derivatives. Weigh the advantages and disadvantages of this finance strategy. Balance is the key to maximizing the potentials of this business tool. It will be good or bad depending on how well you use it.