What is Derivative? Definition and Risk Hedging

derivative definition

What is Derivative?

A derivative is one of the financial instrument whose pay off is derived from an underlying asset. The term derivatives an simply be understood as  those items that do not have their own independent values. They have the unique place in finance as they play an important role in risk management.

No one prefer risk whether firm, financial institutions or a retail investor. Firms only take risk when they get appropriate compensation for the same. The formula is simple. They reduce risk in order to avoid any cash fluctuations. This results in increasing their investments or assets. Every participant in the stock market looks for minimizing their risk. Derivative is a tool to reduce a firm’s risk exposure. They use derivatives and convert risk exposures into quite different forms. This entire process is known as risk hedging through derivatives.

Example of Derivative

Common example of derivative are futures contracts, forward contracts, options, swaps and warrants. And the underlying assets includes bonds, commodities, currencies, interest rates, market indices and stocks.

There are several advantages of better risk management through hedging:

  • Increase focus on operations – Financial risk management requires managers to hedge against possible movements in interest rates and foreign exchange rates. These factors are not under the control of manager nor they can predict them. So, hedging of such risk results in attracting the focus of managers more on operations.
  • Enhancement in Debt Capacity – Financial management helps the managers to understand the investment and manage risk. This results in increasing debt capacity of the firm and interest tax shield.
  • Isolate managerial performance – With hedging, effects of external factor can be separate out. So, if a company is using hedging to manage risk but still organisation performance falls then it is the fault of manager and his management.
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