What are Derivatives?
Imagine buying an umbrella based on the weather forecast for next month. That’s kind of like using derivatives! Learn more in this post.
Derivatives are financial instruments whose value depends on an underlying asset, such as stocks, bonds, or commodities. Say, suppose you go to the farmer’s market with some agreement to hold the price of apples for next month. Instead of actually buying the apples right now, you would rather say to the farmer, “I will purchase these apples next month at today’s price.” This is very much like derivative contracts, as it allows you to speculate or hedge against a price movement while technically not owning the asset itself.
It is significantly powerful tool both for the investors and trader. There are also options and futures contracts that they take in different forms to do this. Wanting to hedge one’s investments against market changes or profit from price movements, understanding it would unlock many avenues for you.
Let’s dive deeper into what makes these financial instruments so intriguing and essential in today’s economy.
Derivatives Trading
Over 90 percent of the world’s 500 largest companies are using derivatives to hedge. A corporation, for instance, could use a futures contract to obtain raw materials at a predetermined price or to safeguard itself from rate changes. By locking in a price for a future transaction, derivatives act like hedging, which protect buyers from price change over time.
Derivatives have a wide range in trading, being able to buy and sell contracts on all different types of things. Nowadays, literally anything can be traded as an derivatives instrument- equities, commodities, currencies, and whatever the imagination can think of. The market is separated into OTC and Exchange-Traded Derivatives, which differ dramatically on many legal aspects and trading.
Types of Financial Derivatives
There are several types of derivative contracts, with options, swaps, futures, and forwards being the most popular. Each type has its unique characteristics and serves different purposes.
Forwards
They are somehow different from futures contracts which are not traded on exchanges and are not standardized but are contracts formed between an agreeing buyer and seller, in which they agree to complete the transaction according to an agreed price at future time. These contracts are tailored to the special needs of the parties involved.
Futures
Futures characterize the stricter derivatives that demand the actual performance of the contract. The parties agree on the price and the due time and sign the agreement that becomes compulsory. The future contracts are standardized and traded through exchanges in an effort to reduce credit risk when the clearinghouse acts as the counterparty to the trade.
Swaps
Swaps are known as contracts that allow or will permit both parties to exchange their cash flows, typically from a fixed cash flow to a variable one. The types of swaps that are quite common with people today include interest rate swaps, commodity swaps and currency swaps.
Options
Options give the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price on or before a specific date. However, in the case of forward contracts, both parties are obligated to complete their side of the transaction, while options allow the buyer the flexibility of actually exercising the option.
Conclusion
Derivatives are among the most complex financial instruments as their values are based on values of an underlying assets. They can be used both for hedging risk and speculation, but they can be very risky if these instruments are not well understood and professionally managed. Just like with any other investment, it is important to find your way around derivatives before engaging with them.
Consult with a qualified financial advisor before getting into derivatives to check if they fit your investment style and risk preferences. With the right knowledge and guidance, derivatives can be a worthy addition to any portfolio, yet not everyone’s cup of tea. We hope this introduction was quite sufficient in bringing you in touch with derivatives!