Legal Definitions - derivative market

A derivative market is a financial marketplace where contracts known as "derivatives" are bought and sold. The value of these contracts is derived from the performance of an underlying asset, such as commodities, stocks, bonds, interest rates, or currencies. Participants in a derivative market use these contracts for various purposes, including hedging against potential risks, speculating on future price movements, or gaining exposure to an asset without directly owning it.

• Example 1: Agricultural Futures

  Imagine a large bakery that uses a significant amount of wheat. They are concerned that the price of wheat might rise sharply before their next major purchase, increasing their production costs. To manage this risk, the bakery enters into a wheat futures contract on a derivative market. This contract obligates them to buy a specific quantity of wheat at a predetermined price on a future date. If the market price of wheat rises, the bakery is protected because they have locked in a lower price. Conversely, if the price falls, they still pay the agreed-upon higher price, but they have achieved price stability. This illustrates a derivative market because the futures contract's value is derived from the underlying asset (wheat), and it's used to manage price risk.

• Example 2: Stock Options for Technology Shares

  Consider an investor who believes that a particular technology company's stock price will increase significantly in the next three months, but they don't want to buy the shares outright yet. Instead, they purchase call options for that company's stock on a derivative market. A call option gives them the right, but not the obligation, to buy the stock at a specific price (the "strike price") before a certain expiration date. If the stock price rises above the strike price, the options become valuable, and the investor can profit by selling them or exercising them to buy the stock at a discount. If the stock price doesn't rise, they only lose the premium paid for the options, which is less than the cost of buying the actual shares. This demonstrates a derivative market because the option contract's value is derived from the underlying stock, and it's used for speculative purposes with limited risk exposure.

• Example 3: Currency Forwards for International Trade

  A U.S.-based electronics manufacturer places a large order for components from a supplier in Japan, with payment due in Japanese Yen in six months. The manufacturer is worried that if the Yen strengthens against the U.S. Dollar over that period, the cost of their order in Dollar terms will increase. To mitigate this currency risk, they enter into a forward contract in the derivative market with a bank. This contract locks in an exchange rate today for the future transaction. Regardless of how the actual exchange rate fluctuates over the next six months, the manufacturer knows exactly how many U.S. Dollars they will need to pay for the Yen. This exemplifies a derivative market because the forward contract's value is derived from the underlying currency exchange rate, and it's used to hedge against foreign exchange risk in international business.