Uses of Derivatives
Price risk for an underlying asset is transferred from one party to another, allowing an investor to hedge against that risk. This can occur both ways, for both parties. For example, a corn grower and a distributor can make an agreement to purchase the corn for a specific price in the future. This means that the farmer can guarantee that price when the corn is sold regardless of the market. In addition, the distributor can ensure that he or she will get a fair market price regardless of the size of the crop's yield.
Speculative investors also find derivatives a good way to acquire risk. This occurs when one party in the contract believes that the other party will be wrong about the value at the time of the sale. This is best leveraged when the speculator can purchase the product at a lower price that the market high. However, this also means that the speculator can end up buying the asset for a higher value than the product is actually worth, taking a loss.
The recent banking crisis and economic recession was attributed banks, brokerages, and other Wall Street firms creating and selling derivatives which were much riskier than anyone thought. Major ratings firms such as Moodys, Standard and Poors (S&P), and Fitch gave these securities AAA ratings. However, they became the toxic assets that weighed down the balance sheets of multiple financial firms and helped contribute to the failures of Lehman Brothers and the government bailout of AIG.