Derivatives are trading instruments, rather than financial instruments for long term investments and investors. Derivatives are used to hedge risks, like hedging currency risks for example between US dollars and Japanese yen or between US dollars and the European euro, besides being used for other activities, including speculation.

Currency risk hedging example:

Say you are a Japanese company that sells cars in the US in US dollars, and then the revenues and profits are transferred back to Japan in the form of yen. Say you sell your car in January, and are expected to transfer the revenues and profits back in the first week of April. Say the US dollar is falling against the Japanese yen, which means that in January 1 (one) US dollar buys 111.00 (one hundred eleven) Japanese yen i.e. 1 USD = 111 JPY, but in April it is expected that the dollar will fall and 1 USD = 108 JPY which implies that each US dollar will be worth less by 3 Japanese yen. Thus, the Japanese car company could buy currency futures contracts that would lock in a particular exchange rate from US dollar to Japanese yen to prevent this loss from a depreciating dollar. This would be a derivative contract with currency being the underlying asset.

Currency speculation example:

Suppose you believe that a currency is going to decline over the next three months. Then you would go “short” on that currency, which means you would sell it now at the higher price, and hope that you’ll be able to buy it cheaper when it goes down in 3 months to fulfill your delivery at a higher price (at which you sold it to create the short position). Thus, you are speculating that the currency will decline, and you’ll profit by covering your short position by buying the currency at a lower price in 3 months to fulfill your part of the trade. In case, the currency becomes more stronger, rather than declining, then you’ll be on the hook to buy it at a price higher than what you sold it for (when you created the short position), thereby incurring you losses, which have no upper limit since the currency could appreciate much more than your capacity to buy. Therefore, such speculation can be catastrophic if the short position works out far worse than you anticipated.

Derivatives are complex financial instruments which require the understanding of the derivatives as well as the underlying asset(s).

I do not plan to dwell further into derivatives since I am more inclined towards long term investments, that is planting trees to get shade for years to come, instead of capturing the fleeting sums of money here and there with their concomitant high risks and potential rewards :).

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