Derivatives

Derivatives are financial contracts whose values are derived from another underlying asset (hence the word derivative). They can come in many forms, the most popular being forwards, futures, and options, for which all have different benefits and contractual obligations.
1. Forwards - a contract that requires for a person to either buy or sell a underlying asset. Requires no initial investment. Everything (expiration date and forward price) is agreed upon today and money nor commodity will exchange hands until the expiration date.
2. Options - there are two types: calls and puts. Both are contracts that give the RIGHT to buy or sell an underlying asset. This is different from a forward because you are not required to go through with the transaction; however, you must may a premium for this additional benefit.
3. Futures- forwards that are exchanged through an exchange market. (For example, Chicago Board of Trade or the New York Mercantile Exchange).
There are many reasons why people and firms deal with derivatives; however, most of them fall into two categories: speculation and hedging. Hedging is the use of derivatives to mitigate risks on a commodity (or any underlying asset) that a firm owns or plans to own in the future. On the other end, speculation is the process of using derivatives with no intention on owning the asset, but to gain high profits. For those who use these contracts to hedge, there are multiple benefits. A top one would be for firms that want to protect themselves from the risk of declining prices. A purchase of a forward contract, a put, or the selling of a call would allow them to benefit from falling prices. In reverse, if firms wants to hedge against increasing prices, they could take the opposing side of the aforementioned contracts. Combinations of these contracts can also be formed. Some will allow infinite amounts of profits, some infinite amounts of loss, and others with a limiting amount on both loss and profits, but a great protection area. Examples of these are collars (purchase of a put and selling of a call), spreads (purchase and selling of calls or puts), and straddles (purchase of a put and call).

Just like any financial strategy, there are those who oppose the use of derivatives. These following criticisms are some reasons people do not engage in derivative usage.
1. Possible large losses - if not used correctly (or the wrong derivatives are used), some derivatives can cause companies a great loss. In fact, losses do not only have to be in terms of when companies actually lose money, but can also be when companies have lost the opportunity to gain money. (This is what I was talking about with ARBC).
2. Counter-party risk - each type of derivative has their own degree of risk. And although the use of these contracts is to minimize risk for the company in general, some combinations of derivatives might not offset each other. (This goes back to being able to efficiently combining the correct strategies).
3. Unsuitably high risk for small/inexperienced investors - To tie this with the first point, large losses can occur when inexperienced investors make bad decisions while using derivatives. For those who don't have the expertise in this area, one small, yet wrong move can be fatal to a firm. Now, companies can get outside, more experienced help to guide them in the financial endeavors. However, this help will not come without a price tag. This is when firms must see if the cost of minimizing their risks through derivatives will truly add value to their firm.

Those were just a few of the hardships that can arise from using derivatives. Although they can happen, it is safe to say that the benefits of derivatives outweigh the criticisms. For both hedgers and speculators, it all depends on what you're looking for. In fact, some people spend their time trying to find arbitrage opportunities (when derivative contracts are unfairly priced, either too high or too low, which will give the opportunity to make money off the market. Usually done by speculators). In any case, these financial contracts have proven to be reliable and valuable to many firms in the past. And I'll make a good assumption and say, it will continue to do so in the future!

(Anand V., Professor of Finance at Georgia State University. Spring 2008. Reference slides can be provided if necessary.)
(Wikipedia.com. http://en.wikipedia.org/wiki/Financial_derivatives#Benefits)
(McDonald, Robert. "Introduction to Forwards and Options." Derivatives Market. 2006. Boston: Pearson Education, Inc.)