What are Derivatives?
Derivatives are financial contracts whose value derives from the performance of an underlying asset, index, rate, or another financial instrument. They are used for various purposes, including hedging against risk, speculating on price movements, and facilitating arbitrage opportunities. Derivatives are versatile financial instruments that serve various purposes in the global financial system. They enable risk management, price discovery, and speculation, but they also require careful consideration of associated risks and complexities.
Geeky Takeaways:
- Derivatives play a vital role in risk management for investors and businesses. By using derivatives, market participants can hedge against adverse price movements in underlying assets, thereby reducing exposure to financial risk.
- Derivatives markets contribute to price discovery and liquidity in financial markets.
- Derivatives offer opportunities for speculation, allowing investors to profit from price movements in underlying assets without owning the assets themselves.
Types of Derivatives
1. Options
Options are financial derivatives that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price within a specified time period. They are widely used by investors and traders for various purposes, including speculation, hedging, and generating income.
Features
- Options come in two primary types: Calls and Puts.
- Call options provide the holder with a chance to buy the underlying asset, with the strike price being the point at which they can exercise their options before the expiration.
- Put options are characterized of giving the holder the right to sell the underlying asset at the strike price until the expiry date.
- They are also short-term contracts that have a particular expiry date and from that point on, they start to devalue and becomes worthless.
- Choices are universally applicable across different applications such as protection, giving away, and income creation through manufacturing options.
Advantages
- Leverage: Opportunities can enable investors to dominate a sizable market share in the asset they want with a conservative capital outlay.
- Flexibility: Investors can employ options for portfolio management and risk reduction, or for betting on price movements, or for collecting income by selling (writing) options contracts.
Disadvantages
- Expiration: The owner of an option has a specific expiry date and beyond which the option will have no value if it has become worthless.
- Complexity: Options trading entails two-fold understanding of complex strategies and valuation techniques that are used in options markets and which are also important to be familiar with, including tenets of sophisticated options valuation models.
Examples
- Purchasing of a call option on a stock for the purpose of aiming profits by expected price rise.
- Buying a put option on a large stock index in order to shield the assets against expected market declines.
- Employing Currency tools to mitigate the Foreign Exchange risk posed by the International Trade.
2. Futures
Futures are financial contracts that obligate the buyer to purchase (in the case of a long position) or the seller to sell (in the case of a short position) a specific asset at a predetermined price on a specified future date. These contracts are standardized and traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE). Futures contracts are commonly used by investors and traders for hedging, speculation, and arbitrage purposes.
Features
- Standardization: Futures contracts are standardized in terms of quantity, quality, and delivery date.
- Long and Short Positions: Participants can take either a long position (agreeing to buy the asset) or a short position (agreeing to sell the asset) in the futures contract.
- Expiry Date: Futures contracts have a fixed expiry date, after which they settle, either through physical delivery of the underlying asset or cash settlement.
- Margin Requirements: Futures trading involves margin requirements, where traders must deposit an initial margin to enter into a futures contract and maintain a maintenance margin to keep the position open.
Advantages
- Liquidity: Futures markets are highly liquid, allowing traders to enter and exit positions easily.
- Price Discovery: Futures markets facilitate price discovery by providing transparent information about supply and demand dynamics.
- Risk Management: Futures contracts are commonly used for hedging purposes, enabling market participants to mitigate price risk associated with the underlying asset.
Disadvantages
- Margin Calls: Futures trading involves margin calls, where traders may be required to deposit additional funds if the market moves against their position.
- Volatility: Futures markets can be highly volatile, exposing traders to significant price fluctuations and potential losses.
- Counterparty Risk: There is a risk of default by the counterparty, although this risk is mitigated to some extent through the clearinghouse mechanism on exchanges.
Examples
- A farmer who sells a determined amount of corn at the predetermined price under the futures contract contingent on the possibility of market price falling to minimize the risk.
- An investor who has decided to take a long position in S&P 500 futures and is using the financial instrument as a speculation tool to anticipate the direction of the S&P 500 stock market.
- A multinational firm using currency futures contracts in international trade transactions deriving benefits from risk hedging in foreign exchange.
3. Forwards
Forwards are financial contracts between two parties that agree to buy or sell an asset at a specified price (the forward price) on a future date (the delivery date). Unlike futures contracts, forwards are typically traded over-the-counter (OTC), meaning they are customized agreements negotiated directly between the buyer and seller, rather than standardized contracts traded on exchanges.
Features
- Forwards are structures whereby two parties confirm, in advance for both, to buy or sell an asset at a set price (the forward price) on some future date.
- They can be somehow tailored in that they can either be asset-based, quantity-based, price-based, or date-based.
- Nonetheless, they are mostly used as a way of fixing the risks of future price movements, but not without a speculative element.
- What distinguishes forwards from options is in the fact that forward contracts compel the parties to fulfill the transaction at the predetermined price and the set date.
Advantages
- Customization: A forward can be used to boil down a contract to bidder-exclusive one in case there is a special kind of asset which is non-standard.
- Price Certainty: Parties can establish a fair fixed price for future transactions, which become handy in an unstable economic environment.
- Hedging: Companies can use the forward contracts to lock-in the prices of future-living assets now, reducing risk in their portfolios.
Disadvantages
- Counterparty Risk: Forward market does not make it clear on which party will pay and which one will receive delivery, so some parties might end up defaulting leading to possible damages for the others.
- Lack of Liquidity: Spot commodities are entered into the market without the formality of standardized exchange-traded contracts and thus, they might be more challenging to exit or benefit from the upside.
- No Flexibility: Being the legally enforceable part of a sale, the entered forward contract abridges any possible flexibility to alter or cancel an agreement without the mutual consent of both parties.
Examples
- An enterprise executes a forward contract to buy the specific amount of crude oil at a specific price that are sixty months from now, being a stretch of time to balance increases in the price factor.
- A speculative investor can sell a forward contract on an index of stock to the other party, and save the selling price at a certain future date from the risk of a decline in the market.
- A multinational corporation does swap transactions beforehand in order to move from present value and give its exports and create an income stream liked to the future received value of the currency it is holding.
4. Swaps
Swaps constitute a financial instrument in accordance with which two parties agree to give flows of cash or other financial instruments of one another for the period of the time they have been specified. These can be employed especially for managing interest rate dangers, currency fluctuations, or even speculating in terms of changing the prices of commodities in the market.
Features
- These swaps call for a trade of cash flows or different types of financial instruments (e.g., bonds) which must comply with the detailed arrangements and conditions established earlier.
- Ordinary swaps categorized as interest rate swaps, currency swaps, and commodity swaps are among the commons ones.
- Such as interest rate swaps, the former somehow involves changing floating interest rate payments for fixed interest rate payments and vise versa depending on the context.
- The process of a modern currency swaps is the conversion of the main amount and the interest payments from one currency to another.
- This can be done by including terms like the principal amount, when and how frequent payments are made, and dates of payment maturity.
Advantages
- Risk Management: Swaps can be defined as a means for rebalancing or transferring certain risks meaning that they fit the interests of participants, regarding interest rate risk and currency risk, and allow to mitigate the influence of unfavourable factors.
- Cost Efficiency: Swaps, moreover, could be great ways to get lower cost entrance to some markets or specific financial objectives, for example, without a need to have ownership of the assets.
- Customization: The flexibility of swaps as an option of customizable contracts gives parties the authority to customize the contract to their demands, yet still enhance their directing of risk management or investment.
Disadvantages
- Counterparty Risk: The swaps agreement can be considered as a counter party risk from the perspective of the parties being exposed to the risk that the other party may fail to timely perform its obligations.
- Complexity: Swaps are in fact financial products that are very complex and therefore a deep immersion into the markets, valuation methods, and legal papers is required.
- Market Risk: Swaps are exchange of one payment stream for another which may either be fixed or floating. Changes in market conditions, like interest rates or currency exchange rates, can impact the value of a swap and may incur losses for the parties involved.
Examples
- The company could use an interest rate swap in which the company with a variable rate loan of about 5% interest rate swaps payments with another party who owns a fixed rate loan interest rate of about 8% and this would help reduce interest rate exposure.
- One example of currency swap could be the arrangement between two multinational corporations to exchange cash flows generated in difference currencies instead of constantly resisting against the exchange rate risks in foreign transactions.
- An effective approach of commodity swap in which agreement has been reached by a producer to sell his/her commodity at a fixed price to a financial entity in return for its finance the variable market prices, this creates a more stable revenue.
Conclusion
To successfully invest or trade or to work in the financial sector, it is necessary to learn and understand the ways derivatives are used. Derivatives comprise of various category where every type of derivative is linked to some of its specific character, feature, benefits, drawbacks and examples based on the investor’s choice of risk profile, purpose of investment and market circumstances. Among the derivatives’ strengths is that they encompass the analysis of the market participants on risks, portfolio strategies, and global financial market opportunities.