Lesson 2 of 5 · 12 min
Firm commitments, contingent claims and why derivatives are used
Derivatives come in two families, firm commitments that both sides must honour and contingent claims where one side chooses, and they widen what investors and issuers can do beyond the spot market.
In short
- A firm commitment fixes an exchange that must take place at settlement: forwards, futures and swaps.
- A contingent claim lets one counterparty decide whether (and sometimes when) the trade settles. The option is the main contingent claim.
- Derivatives let participants sell short, diversify, offset commercial exposures, create large exposures with a small cash outlay, and trade at lower cost and often with more liquidity than the spot market.
- Hedging means using a derivative to offset an existing or anticipated exposure; the derivative is then called a hedge.
- Derivatives can increase exposure as well as reduce it.
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