What are Financial Derivatives

Financial derivatives are financial instruments whose value is derived from the value of an underlying asset or group of assets. The underlying assets can be anything from stocks, bonds, commodities, currencies, or even interest rates.

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The value of a derivative depends on the value of the underlying asset, and can be used for a variety of purposes, such as hedging against price fluctuations, speculating on future price movements, or obtaining exposure to an asset without actually owning it.

There are several types of financial derivatives, including futures, options, swaps, and forwards and we are going to talk about them in this article.

KEY TAKEAWAYS

Financial derivatives are financial instruments whose value is derived from the value of an underlying asset or group of assets. The underlying assets can be anything from stocks, bonds, commodities, currencies, or even interest rates.
Futures contracts are often used to offset risk for commodities, shares, or currencies.
It is important to note that aggressive speculative strategies carry increased risks.
Futures contracts are often used to offset risk for commodities, shares, or currencies.

What are Financial Derivatives

Derivatives are a type of financial instrument used by traders to access specific markets and assets. These complex securities involve agreements between two or more parties and are commonly used for advanced investing.

The underlying assets for derivatives can include stocks, bonds, commodities, currencies, interest rates, and market indexes, with the value of the contract dependent on changes in the underlying asset's price.

In other words a derivative is a contract between two parties that derives its value from an underlying asset, security, or index. The underlying assets can include stocks, currencies, commodities, bonds, and interest rates.

In simpler terms, a derivative is any security whose value is based on the value of a different asset. Futures and options are examples of widely traded derivatives, but there are many other types available.

Why investors need derivatives:

Attempt to reduce market risks that arise from transactions with underlying assets, that is, to use hedging strategies, where a transaction can be made on predetermined terms.

The futures market provides wide opportunities for implementing various trading strategies, including speculative ones.

There are additional possibilities here: to make a transaction, it is not necessary to pay the full cost of the contract, providing only the amount of margin collateral. For example, this may be around 10-20% of the transaction amount. The size of margin collateral is set by the exchange.

By blocking only margin collateral, the so-called leverage effect arises - compared to buying the underlying asset for the same amount, more derivative instruments can be purchased. Risks and profitability increase proportionally.

It is important to note that aggressive speculative strategies carry increased risks. It is necessary to carefully assess the proportion of capital that the investor is willing to risk. An important condition, especially for a novice investor, is the ability to relate risks and manage them within the framework of their portfolio strategy. It is necessary to monitor the sufficiency of funds for margin collateral to avoid the broker forcibly closing the position.

With the help of instruments of the futures market, one can not only speculate or hedge their obligations (for example, a currency loan), but also use an arbitrage strategy.

Arbitrage is several logically related transactions aimed at extracting profit from the difference in prices for identical (or related) assets: at the same time on different markets (spatial arbitrage) or on the same market at different times (temporal arbitrage).

Why Use Derivatives

There are several reasons why trades use derivatives. Let's check them out.

Hedging

One of the main uses of financial derivatives is risk management and position hedging. This involves minimizing the risk of unfavorable movements in the price of an asset by taking the opposite position in the same or a related asset. Financial derivatives contracts are ideal for hedging since they allow traders to profit from falling price movements through short-selling.

For instance, if an investor owns 100 shares in Company X, bought at $100 per share, and is concerned that the share price will fall, they may choose to hedge their position by buying a derivative product that increases in value if the price of the shares falls. This will insure the investor's position against a possible decline in the price of the shares.

Speculation

Financial derivatives can also be used for speculation, with the aim of profiting on price fluctuations of an underlying asset. Unlike traditional investment products, derivative contracts allow traders to profit from price decreases through short-selling, as well as price increases through long-selling. Furthermore, traders are not required to have physical ownership of an asset to profit from short-selling it.

Leverage

One of the most attractive features of financial derivatives is the ability to leverage. Leverage allows traders to open a position by only paying a percentage of its cost, enabling them to gain exposure in a market that is several times higher than their investment account's capital. Using leverage can increase potential profits without increasing the starting capital. However, it is essential to note that leverage also amplifies potential losses if the market moves against the trader.

How do Derivatives Work

To understand the basic principle of how derivatives work, let's take a simple example.

You live in a village and somehow learn that in a month's time, the business of selling milk to the city will become very profitable in your area. You rent a few cows from a farmer for a certain period, leaving a deposit. At the same time, you do not take on any obligations to take care of the animals, i.e., you do not spend money beyond the deposit.

And a month later, it becomes very fashionable and profitable to transport milk for sale in the city from your village, so the demand for renting cows sharply increases. You begin to rent out the animals at a high price, making yourself rich.

However, the situation could have turned out differently - selling milk in the city might not have become a popular activity among your fellow villagers. In this case, you would have wasted money on renting cows.

In reality, securities play the role of cows. For example, you can arrange with a trader that you will buy "X" assets from him for 200,000 dollars in a year. If by that time the real value of these assets grows to a million dollars, you will get them at the price agreed upon a year ago, becoming several times richer.

Types of Derivatives

Derivatives are contracts that derive their value from an underlying asset and are commonly traded online through either an exchange or over-the-counter (OTC). The three most popular types of derivative contracts are futures, options, and CFDs.

CFDs

CFDs allow traders to speculate on the price movement of global instruments like shares, currencies, indices, and commodities without actually holding the underlying asset. They can be traded both ways, on rising or falling markets, providing flexibility and opportunities for profit.

Futures Contracts

This type is often used to offset risk for commodities, shares, or currencies. Companies can lock in a reasonable price for raw materials to protect themselves from future price hikes, currency exchange rate changes, or interest rate changes. Index futures and currency futures reflect current investor sentiment and take into account interest rates, and their prices change based on the supply and demand of the underlying asset and contracts. Futures are standardized and can be offset or liquidated before expiry.

Options

Options give traders the right but not the obligation to buy or sell an underlying asset at a specified price on or before a certain date. This differs from futures as the holder has no obligation to buy the underlying asset.

Forward Contracts

Forward contracts are similar to futures but are traded through a broker, and the agreement is more informal. The price is set and paid for on a future date and can be renegotiated, extended or closed early for a premium.

Swaps

Swaps are customised OTC contracts between two parties, usually not traded by retail investors, and not traded over exchanges. They involve exchanging cash flows or liabilities for two different securities over a set period of time, such as interest rates.

Pros and Cons of Derivatives

Derivative financial instruments offer many opportunities for profit, but all of them are somehow associated with risks.

Advantages

In traditional transactions, investors can only earn on the increase in asset prices, while in derivative transactions, they can also profit from price decreases.
With favorable circumstances and competent management of transactions, it is possible to achieve very high profitability in a short period of time.
Low entry threshold that does not require an investor's license.

Disadvantages

Failure to fulfill obligations (especially in option schemes).
Lack of legislative regulation.
Difficulty in predicting changes in asset prices.
The process of learning to work with derivatives is often associated with significant costs.

Bottom Line of What are Financial Derivatives

In conclusion, financial derivatives are financial instruments that derive their value from an underlying asset or benchmark, such as a stock, bond, commodity, or index. They are used to manage risk, allocate assets, and create new instruments with unique payout functions. The most common types of derivatives include options, futures, forwards, and swaps, which are traded on organized and over-the-counter markets.

While derivatives offer benefits such as risk redistribution and cost reduction, they also pose significant threats and must be used with caution. Overall, the market for derivative financial instruments is dynamic and continuously evolving, reflecting the ongoing trend of globalization in the financial system.