Purposes of Use of Derivative Products
Today, Derivative Products are used for 3 main purposes. The first is Hedging, the second is Speculation, and the third is Arbitrage. Derivative Products are derived from assets traded in spot markets and are used to reduce or completely eliminate interest, exchange rate and price risks in the markets. Derivative products are financial instruments whose prices are determined depending on the price of the underlying security product in the spot market. Throughout history, derivative products have been used to hedge against price fluctuations and to speculate and predict what prices will be in the future. If you wish, let's examine these three purposes of use in more detail.
Risk Protection (Hedging)
Hedging is the most common use of derivative products. Hedging is a strategy of using derivative products to prevent or reduce loss from future price changes of an asset traded in the spot market. For example, if a company borrows money in foreign currency, it is exposed to exchange rate risk. In order to reduce this risk, the company can purchase a forward foreign exchange contract or foreign exchange option in order to fix the foreign currency amount to be paid at maturity of the debt. Thus, the company can pay its debt at a predetermined rate even if the exchange rate rises in the spot market.
Speculation
Speculation is another use of derivative products. Speculation is the strategy of using derivative products to profit from future price changes of an asset traded in the spot market. For example, if an investor predicts that the stock price will rise, he can purchase a call option on the stock at a lower cost instead of buying the stock. Thus, when the stock price rises in the spot market, the investor can use his option to buy the stock at a lower price and make a profit equal to the difference.
Arbitrage
Arbitrage is the end use of derivative products. Arbitrage is a strategy of utilizing derivative products to obtain risk-free profits from price differences between the same or similar assets traded in the spot market and the derivative market. For example, let's say a stock is worth 100 TL in the spot market and 105 TL in the forward market. An arbitrageur can earn a risk-free profit of 5 TL by purchasing a stock for 100 TL in the spot market and simultaneously making a stock sale contract for 105 TL in the forward market.