There is an array of investment avenues available to investors as per their risk-taking capability. An intelligent investor understands that as risk increases, the probability of higher returns increases and there is no certainty of such higher returns. The whole investment activity revolves around risk reduction, if not elimination. Investors formulate various strategies to reduce risk. One such strategy can be to invest in derivatives. Derivatives are instruments, which derive their value from some other variable and not from themselves. The value of derivative is derived from the underlying variable. This article discusses some aspects of derivatives.

The participants on the market are interested in maximum spread. The objective of investors is to either earn more profits at a given level of risk or reduce risk for specified returns. Risk in case of investments is the probability of deviation of actual returns from the anticipated returns. For risk management, investors espouse various strategies. Risk reduction requires smart analysis, backed by sound knowledge and timely execution of correct decisions pertaining to investment in various avenues. Risk can also be reduced substantially by careful selection of investment instruments. Not all instruments safeguard against expected changes in their future prices. A way to safeguard against future prices is to enter into a contract to trade the instrument at a specific price on a specified date. For risk management, derivatives come to the rescue of investors. Derivatives are instruments, which derive their value from the underlying. Derivatives are abstractions, whose value is derived mathematically from the changes in the value of underlying. The underlying can be anything. It can be scrip, commodity, index, currency or even some other variable. Nearly every derivative is an agreement between a future buyer and future seller, to enter into the trade at a specific price, on a specific date. Thus, the common elements of any derivative are buyer, seller, underlying, future price and future date.

Derivatives are abstract instruments containing a contract to be executed on a future date. Derivatives are used as tools of risk management by hedgers and for the purpose of earning profits by speculators. Hedge is a way of protecting, limiting or controlling something. Derivatives are excellent tools for risk management through hedging. Hedging in relation to the activity of investing denotes protection against risk, arising out of unanticipated changes in future prices of instruments. Hedging is recognizing and measuring the financial risk of an existing position and then taking on new position with opposite exposure characteristics, such that the gains or losses of the two positions cancel out each other.

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