What are financial derivatives?

A derivative is a financial contract that derives its value from the performance of an underlying asset. The underlying asset can be anything from stocks and currencies to interest rates and indices. Commodities such as oil and gold are also often used in derivative contracts. Although the importance of derivatives has risen over the past few decades, they can be traced back several centuries. Futures on rice were traded in Osaka, Japan, as early as the 18th century.

Derivatives are used for a number of purposes such as insuring against price movements (hedging), speculating, or getting access to otherwise hard-to-trade assets. Simply said, the buyer of a derivative contract agrees to purchase the underlying asset at an agreed-upon price on a specific date in the future. On the other side, the seller of the derivative doesn’t have to own the underlying asset.

Derivatives, together with stocks and debt, form the three main categories of financial instruments. They can be further broken down into “lock” and “option” derivatives, with the main difference being that lock derivatives oblige the contractual parties over the lifetime of the contract (such as futures and forwards), whereas option derivatives provide the buyer the right, but not the obligation, to act under the specified terms.

Financial derivatives can be further divided depending on where they are traded. Derivatives such as swaps and forwards are traded on over-the-counter (OTC) markets, while other types of derivatives such as futures and options are traded on exchanges.

There are many types of derivatives, but the most common are: forwards, futures, options, swaps and their variations such as collateralised debt obligations and credit default swaps.

Futures

Futures contracts, or just futures, are standardised forward contracts that oblige the contractual parties to buy or sell the underlying asset at the agreed-upon price at a specific time in the future. The predetermined price of the underlying asset is called the forward price, while the specified time in the futures contract is called the delivery date. The underlying asset is usually a financial instrument such as a stock or currency pair, or a commodity such as oil or gold. As a standardised contract, futures are traded on regulated futures exchanges.

Among the first futures contracts were those with agricultural commodities or natural resources as the underlying asset. The first financial futures date back to 1972 and play an important role in today’s financial markets.

Futures were originally used to hedge against price fluctuations by allowing one to fix prices for a specified date in the future. This is usually the case when an investor wants to reduce his foreign exchange risk; when he expects payments in foreign currencies, by fixing the rate at which he can exchange the foreign currency. Today, futures are also used for speculation by buying or selling futures contracts in which the agreed-upon price at which the buyer will buy or sell the underlying asset is expected to yield a profit.

Forwards, on the other hand, are very similar to futures with the main difference being that they are not standardised and thus are traded on over-the-counter markets.

Options

An option is a financial contract which, unlike futures, gives the buyer the right, but not the obligation, to buy or sell the underlying asset at the agreed-upon price on a specific date in the future. If the buyer decides to exercise the option, the seller has the obligation to meet the contract’s requirements. The agreed-upon price in an option is called the strike price.

Depending on the buyer’s right to buy or sell the underlying asset, option contracts can be classified into “put” and “call” options. Put options give the buyer the right to sell the underlying asset at the specified strike price, while call options give the right to buy the underlying asset at the specified strike price.

The ownership of an option does not entitle the holder of the option to voting rights, dividends, or any other right associated with the underlying asset.

Swaps

Swaps are derivative contracts in which two parties agree to exchange cash flows of one party’s financial instrument for cash flows of the other party’s financial instrument. These streams of cash flows are called the legs of the swap contract. At the time when the swap contract is initiated, usually at least one of the cash flows is determined by floating interest rates, foreign currencies, equity prices etc.

According to the Bank for International Settlements, there were almost 350 trillion USD in interest and currency swaps outstanding in 2010; making swaps one of the most traded types of financial contract in the world.

Variations of financial derivatives - Credit Default Swap (CDS) and Collateralised Debt Obligation (CDO)

Credit default swaps are a type of swap contract where the seller of the contract agrees to compensate the buyer in the event of a loan default. The buyer makes a series of payments to the seller, called the CDS “fee”, and in return receives the face value of the loan in the event of a loan default.

Collateralized Debt Obligations are also a variation of financial derivatives, which pool together various assets and repackage them into tranches that are then sold to investors. The pooled assets consist primarily of debt obligations such as bonds, loans and mortgages, and the CDO tranches vary significantly in their risk profile depending on the priority on the debt’s collateral in case of a default.

Limitations of derivatives

The famous investor, Warren Buffet, stated in Berkshire Hathaway’s 2002 annual report that derivatives are “financial weapons of mass destruction,” as their increasing market value could distort the markets of the underlying assets themselves. This could lead to a chain reaction and even trigger a new financial crisis.

Derivatives can include a broad range of underlying securities, and investors need to be fully aware of the characteristics of derivative contracts to reduce the risks associated with them. In addition, investors should know the risks of the counterparty, and the contract’s price and expiration.

Due to their very nature, derivatives are also subject to some limitations. For example, investors often use derivative contracts such as futures or forwards to hedge and diversify their portfolio, assuming the existence of a negative correlation between the underlying asset and some other asset classes. However, correlations can vary and even completely change over time, putting the investor at higher risk than he would be without the use of a derivative contract.

Finally, derivatives are usually based on high leverage to allow investors to earn large returns from small movements in price, but leverage can also significantly increase losses if the price moves against an investor’s predictions.

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