When boiled down to the basic elements, all financial fields have the specific aim of maximizing profit for investors while minimizing the risk that these individuals undertake. In order to facilitate these results, a number of financial instruments can be used to reduce the risk that an individual may experience in any investments, whether investing in shares or buying gold.
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Swaps and futures are some of the most popular tools in this group as they are easy to understand and serve as a type of financial protection to prevent loss in financial transactions. These tools are indispensable, without them, investors would face much more risk in terms of their investments. However, derivative abuse can and has occurred in the past.
In essence, futures are contractual agreements between two separate parties that allow the purchase and sale of goods for an agreed upon price at the start of the contract, with delivery occurring at an agreed upon future date. As such, these contracts are designed to protect the purchaser in the event of a significant price shock and other economic maladies while protecting sellers in the eventuality of a price decrease. Depending on which side of the contract one is on, futures can be used to speculate or hedge.
As a tool for speculation, futures contracts assist parties by betting on the rise or fall of an asset price. Through these measures, speculators can profit in the event that their price predictions are correct. However, speculators have much to lose in the event that their predictions are wrong as asset prices in certain markets have a habit of significantly swinging.
Futures are particularly useful in aviation and agricultural industries as fuel and food costs can fluctuate wildly between seasons. Through the use of futures, contracted parties have a basic idea of what prices will be like in the future, and have a minimum level of income that they can derive from their products.
While swaps function in a highly similar manner to futures, there are significant differences in the rules and regulations behind their issuance and benefits. Swaps are typically used in currency exchange markets as they are a powerful tool for hedging against interest rate changes. Swaps are a contractual agreement between two separate parties in which an exchange of cash flow and interest rates are to occur at a future date.
These exchanges are based on a fixed or floating exchange rate, and serve as a highly liquid form of derivatives. These transactions are particularly beneficial for both risk-averse and risk prone companies, as the use of swaps can benefit a particular party in the event that the reference rate (LIBOR or EURIBOR) drops or increases. However, due to its nature, individuals are contractually bound to endure the exchanges, even when, not in their favor.
As can be seen, swaps and futures are highly useful in managing risk within financial transactions as they allow parties to minimize this risk by distributing it between multiple parties. However, there are inherent risks in excessively using derivative instruments, and this risk manifested itself in the occurrence of the 2008 financial crisis. If derivatives are properly managed, they are an excellent tool for financial management.
Bernard Mopes is a freelance writer based in Toronto, Canada. Bernard focuses his research and writing on finance, accounting, taxation, banking, investment advice, business and other related topics.