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What is the Connection Between Derivatives and Risk Management?

By Dana DeCecco
Updated May 17, 2024
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Derivatives are used for speculation and risk management. The connection between derivatives and risk management are exhaustive. Derivatives are used by corporations and financial institutions to create trading strategies designed to mitigate risk. Individual investors can use derivatives to create risk aversion methods that provide potential profit objectives. Derivatives and risk management techniques offer a virtually unlimited variety of market performance strategies.

Over-the-counter (OTC) derivatives are used by financial institutions to create custom strategies designed for specific trading situations. Exchange traded derivatives are commonly used by institutional and retail investors to speculate and hedge financial markets. Counterparty default is eliminated by the use of exchange traded derivatives because all trades are cleared through a central clearinghouse.

Retail investors access derivatives and risk management systems through futures and options exchanges. Futures exchanges offer derivatives on commodities, currencies, equity indexes, and financial securities. Futures contracts are derivatives designed to purchase or speculate on the future price of an asset. Major corporations use futures contracts to manage the risk involved with buying and selling commodities. Farmers use futures contracts to hedge weather conditions and crop production.

Options contracts are derivatives used for speculating and hedging equities, futures, and other financial securities. Trading options involves the buying and selling of puts and calls. Simple and complex positions can be created to manage risk in a variety of market conditions. Derivative contracts are highly leveraged and afford the opportunity to control large amounts of assets with a relatively small deposit.

Hedging techniques are designed using derivatives and risk management methods. Hedging a position in a security involves limiting or offsetting the risk of an adverse price movement. The leverage available with derivatives make them the ideal financial instrument for hedging investments. Option premiums are paid to hedge portfolios against adverse market declines including systemic and market risk. The premium paid is a small percentage of the account value and is used much like an insurance policy.

Derivatives are a cost effective means to employ risk management tactics for hedging and protective purposes. Custom tailored strategies can be created to accommodate retail as well as institutional investors. International commodity trading depends on risk management solutions provided by futures derivative contracts. Risk management techniques are best employed through the use of derivative products.

Futures and options are the most common form of derivative trading. Retail traders use these markets primarily for speculation on a wide range of securities. Risk management and hedging products are available to the trader interested in protective strategies.

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