What Are Financial Derivatives?
A financial derivative is a two-party contract whose value is derived from an underlying asset or collection of assets. stocks, bonds, commodities, currencies, or interest rates are all examples of underlying assets.
Definition 2
Financial derivatives are instruments with payoffs linked to previously issued securities, used as risk reduction tools.
More Thorough Understanding of the Term
Derivatives allow investors to speculate on the underlying assets' future prices without owning them. Investors use them to hedge against risks or to speculate on market fluctuations. Investors use financial derivatives for various purposes, including hedging, speculation, and arbitrage.
Hedging is a strategy for mitigating risks, such as price variations in underlying assets, whereas speculating is a strategy for profiting from price changes in underlying assets. Arbitrage is simultaneously purchasing and selling the same item in multiple marketplaces to profit from price differences.
Investing in financial derivatives is fraught with dangers such as counterparty risk, market risk, and liquidity risk. Counterparty risk is the chance that one party would fail the contract. In contrast, market risk is the risk that the value of derivatives will be affected by underlying asset price variations. The danger that derivatives will be challenging to sell in a volatile market is known as liquidity risk.
Types of Derivatives
Futures, options, swaps, and forwards are the four primary types of financial derivatives.
- Futures
A futures contract is an agreement between two parties to acquire or sell an underlying asset at a future date and price. Futures contracts are standardized and exchanged on exchanges that are regulated. Investors use them to protect themselves against price variations in the underlying assets or to bet on market movements.
- Options
A contract that offers the buyer the right, but not the responsibility, to buy or sell an underlying asset at a preset price and date in the future is known as an option. Call options and put options are the two forms of options. The buyer of a call option has the right to buy the underlying asset, whereas the buyer of a put option has the right to sell the underlying asset.
- Swaps
A swap is an agreement between two parties to exchange cash flows according to a set formula. Swaps are used to protect against interest rate and currency volatility. Swaps are classified into three types: interest rate swaps, currency swaps, and credit default swaps.
- Forwards
A forward contract is an agreement between two parties to acquire or sell an underlying asset at a future date and price. Forward contracts, unlike futures contracts, are not standardized and are sold over the counter (OTC). Investors use them to protect themselves against price variations in the underlying assets or to bet on market movements.
Examples
Example 1: Hedging
Investors use derivatives to protect themselves against risks such as price volatility in the underlying assets. A farmer, for example, may utilize a futures contract to lock in the price of his crop before harvest, protecting himself against price changes.
Example 2: Speculation
Investors use derivatives to speculate on market fluctuations in the hope of profiting from price changes in the underlying assets. For example, a trader may purchase a call option on a stock that he feels will rise in value to sell later at a profit.
Example 3: Arbitrage
Arbitrage is simultaneously purchasing and selling the same item in multiple marketplaces to profit from price differences. Investors utilize derivatives to profit from price differences between underlying assets and their derivatives.
In Sentences
- Financial derivatives are complicated financial instruments that can serve a variety of functions.
- Investors regularly utilize derivatives to hedge against risk or speculate on market changes.