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Can the derivatives be viewed as an investment instrument?

It is said that derivatives are both a risk management tool for management to hedge risk as well as a speculative device that destabilizes prices, misallocates resources, and bankrupts many companies and government.

Can the derivatives be viewed as an investment instrument? Explain your answer with relevant examples and clearly state your conclusion or opinion.

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It is said that derivatives are both a risk management tool for management to hedge risk as well as a speculative device that destabilizes prices, misallocates resources, and bankrupts many companies and government.

Can the derivatives be viewed as an investment instrument? Explain your answer with relevant examples and clearly state your conclusion or opinion.

Derivatives are instruments that enable you to hedge your portfolio or open positions in the market. (Icicidirect, 2008) The purpose of hedging activities is to insulate a business from changes in market prices or rates over which management has little or no control. Management makes plans based on expectations of what prices will be. If there are significant differences between the expected prices when plans were made, and the actual prices when the plans are implemented, actual results may be far different from expectations.

Hedging activities essentially allow management to protect against price changes by either locking in the current price, or locking in today the price expected at some future date. Derivative financial instruments are particularly useful in hedging against a number of price risks. (Source: A Primer on the Economics of Hedging Using Derivatives by Walter R. Teets and Robert Uhl).

For example Option contracts allow you to run your profits while restricting your downside risk. Apart from risk containment, options can be used for speculation and investors can create a wide range of potential profit scenarios. An example of derivative is a currency call option. A currency put option, such as the one appropriate, gives the buyer the right, but not the obligation, to sell a specified number of foreign currency units to the option seller at a ...

Solution Summary

This solution discusses derivatives and investment instruments.

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