Hedgers | Speculators | Derivatives Contract | Underlying | Risk Aversion | Financial Contract |
Today if you look
around the world, almost everyone and everything is exposed to some sort of
risk. If you talk about a person or a business entity all of them are exposed
to some type of uncertainty.
Here by risk, we
simply mean deviation from the expected outcome. What if, in a situation, the
outcome turns out to be, adverse than expected?
For example, for
an Oil producer, the risk is reduction in the oil prices which will result in
decline in revenue and profits. For a wheat farmer, the risk is reduction in
prices of wheat grown.
Now assuming
rationality, everyone whether Oil producer or farmer wants to reduce or
eliminate the risk of adverse outcome which we just discussed above.
So in a general
sense, everyone is risk averse. But the risk aversion level of everyone is
different. Someone is highly risk averse and wants to play safe. Whereas others
might be low risk averse and would love to take a certain level of risk if that
provides an opportunity to earn some return.
Also everyone has
different opinions and forecasts of how the specific events will turn out in
future. In our scenario as discussed above, two people will have different
views on future oil prices or wheat prices, if they will rise or fall.
Thus, this
difference in level of risk aversion added with different opinions and
forecasts about the future creates a market where people with opposite views
will enter into a contract.
What type of
contract?
For an Oil
producer who is afraid of oil price falling would like to enter into a contract
which would limit the exposure to losses if oil price really falls in future.
Now there will be someone, say Person A, who is less risk averse and is of the
view that oil prices will not fall but rise and is even ready to take risk to
earn from his view.
So they will
enter into a contract, that if the price of oil falls Person A will pay to the
Oil Producer the amount by which the price of Oil falls and if the price of oil
rises, the oil producer will pay person A, the amount by which the price of oil
increases.
Here in the above
case, the Oil producer being into the oil production industry is Hedger as he
is trying to reduce his risk exposure towards fall in oil prices in future. And
the person A with a different view is Speculator.
If oil price
rises, the Oil producer will have to pay to Person A but that will be covered
from selling oil at high prices, so still will be able to earn normal profits.
But if oil prices fall, at least he will not make a loss as he will be paid by
Person A.
For Speculator
i.e., Person A, who wanted to gain from his view, if oil price rises will make
profit from his view and if oil prices fall, he will need to pay the difference
to the oil producer.
What actually
happened in the above contract?
The Oil producer
who was highly risk averse transferred the risk of oil price falling to the
Person A who was low risk averse and had an opposite view of oil price rising
and was ready to take risk to make profit from the possibility of his outcome
turning out to be true.
The thing on
which the contract is entered is Oil which is known as the underlying. Both
have different views on the underlying, hence contract was possible.
And the value of
this contract will be the difference in the current oil prices and the future
oil prices which will turn out to be either high or low or the same. That
difference will be paid either by oil producer to Person A if oil price will
rise or Person A to oil producer if oil price will fall.
As the value of
the contract is derived from the underlying that is here oil, the contract is
known as Derivative.
So we can define
derivative as
Derivative is a
financial contract which derives its value from an underlying.
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