A financial derivative is a financial contract which derives its value from one or more underlying assets, for example stocks, bonds, currencies, market indices and commodities. Derivatives are used in a variety of ways, most commonly to hedge a position, for leverage or to speculate on future price movements of a given asset. They are usually traded over the counter, but some are traded within specialized exchanges
Types of Financial Derivatives
The main types of derivatives are options, forwards and futures, and swaps. Forwards and futures are financial contracts that compel a buyer to buy an asset for a pre-agreed price on a given date in the future.Forwards and futures are pretty similar. However, forwards are more flexible since they give either party the option to customize the underlying commodity, its quantity and the date of the transaction. In addition, futures are only available on futures exchanges.
Option contracts allow but don’t require the buyer to buy or sell the underlying asset at a predetermined price (strike price) on or before the expiration date. The price of the option varies depending on factors such as the price of the underlying asset relative to the strike price, how much time is left until expiry, and price volatility of the underlying asset. Standardized options are traded on exchanges with strict specifications, similar to those on futures exchanges.
Swaps allow the buyer and seller to exchange cash flows. They usually involve swapping a fixed cash flow for floating cash flow. Common swaps include currency swaps, commodity swaps and interest rate swaps.
Benefits of Derivatives
A major benefit of financial derivatives is hedging risks. The value of the derivative is linked to the value of the underlying asset. Therefore, if an investor buys a derivative contract whose value moves in the reverse direction of an asset he/she owns, the investor will offset losses in the underlying asset with gains from the derivative.
In addition, derivative contracts expose investors to assets and markets that they previously could not access. Moreover, derivatives can be used to determine the price of the underlying asset. Lastly, derivatives increase efficiency in the financial markets by replicating the payoff of assets, reducing arbitrage opportunities.
Shortcomings of Derivatives
While derivatives contracts have several benefits, they are also associated with some drawbacks. To begin with, they are highly volatile and could result in major losses for investors. Additionally, they are highly speculative. When paired with their inherent riskiness, unreasonable speculation could result in massive loss. Lastly, some derivatives that are traded over the counter do not have provision for due diligence, creating default risk.
In conclusion, derivatives provide an attractive opportunity to make profits without necessarily forcing the investor to commit substantial funds at the onset. However, they are complex instruments which require expertise in order to be applied successfully. Consult a qualified investment manager or financial advisor before entering the derivatives market.