Identify the underlying exposure

A derivative references an asset or variable, but its price need not equal the spot price. The importance of maturity, financing or volatility depends on the instrument. One formula cannot describe every contract.

Distinguish rights from obligations

An option buyer generally purchases a right while the seller accepts an obligation. Futures create their own contractual responsibilities. Identify the position's side before assessing margin, expiry handling and funding needs.

Hedges may not match perfectly

A business may use derivatives to reduce uncertainty over future costs. Differences in quantity, timing or product can leave residual exposure. A hedge should explain both the risk covered and the risk remaining.

Check a hypothetical hedge

Suppose a business needs one raw material but considers a contract on a related commodity. The prices may usually move together while their difference still changes. Compare the actual purchase, contract reference and required date to identify the exposure that remains unmatched.

Source and reading notes

This is an independently written educational overview based on the ATFX reading linked below. Examples are illustrative, not live quotes or forecasts. It does not reproduce the original article or imply endorsement by its author.