Why buy derivatives?
There are two main reasons for buying derivatives: speculation and hedging. Some securities, like contracts for difference, can also offer investors a way to trade in assets without the need to physically own that asset – for example, you can buy or sell the price of crude oil, without having to make room in your garage for all those barrels!
Many institutional investors include a number of derivative financial instruments in their portfolios. They don’t tend up make up the core of a portfolio, these are typically safer assets, such as government bonds, which are there to provide a secure, albeit low-yielding annual income.
Instead, derivative contracts are seen as so-called ‘satellite holdings’ – things that investors can have a bit of a gamble with to try and make bigger, or higher-yield, returns. This is speculation.
Investment derivatives can be used to offset some of the risk already present in a portfolio – and this is called hedging. For example, if a portfolio contains corporate bonds, credit default swaps can be used as insurance against default on those bonds.
There are many other examples of hedging, but let’s come back to that – and look now at some of the different types of derivative in a bit more detail. First, let’s examine some of the more common products that are easier to trade and understand.