What is a financial derivative?

What is a financial derivative? The easiest way to explain a derivative is that it is a contractual agreement where a base value is agreed upon by means of an underlying asset, security or index. There are many underlying assets that are contracted to various financial instruments such as stocks, currencies, commodities, bonds and interest rates. A simpler definition of a derivative is that it is any security whose value is derived from the value of a different asset. There are a number of common derivatives which are frequently traded all across the world. Futures and options are examples of commonly traded derivatives. However, they are not the only types, and there are many other ones.

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Derivatives Market

The derivatives market is extremely large. In fact, it is estimated to be roughly $1.2 quadrillion in size. The reason why it is so large is that there are derivatives available for many different assets including bonds, stocks, commodities, currencies, etc. Many investors prefer to buy derivatives rather than buying the underlying asset.

The derivatives market is divided into two categories: OTC derivatives and exchange-based derivatives. OTC, or over-the-counter derivatives, are derivatives that are not listed on exchanges and are traded directly between parties. Therese types are very popular amongst Investment banks.

Exchange-based derivatives are ones that are listed on exchanges, such as The Chicago Mercantile Exchange. It is common for large institutional investors to use OTC derivatives and for smaller individual investors to use exchange-based derivatives for trades. Clients, such as commercial banks, hedge funds, and government-sponsored enterprises frequently buy OTC derivatives from investment banks.

Types of Derivatives

There are a number of financial derivatives that are offered either OTC (Over-the-counter) or via an Exchange. Derivatives values are affected by the performance of the underlying asset or, as mentioned, the contract. The more common derivatives used in online trading are:

✓ CFDs

CFDs are highly popular among derivative trading, CFDs enable you to speculate on the increase or decrease in prices of global instruments that include shares, currencies, indices and commodities. CFDs are traded with an instrument that will mirror the movements of the underlying asset, where profits or losses are released as the asset moves in relation to the position the trader has taken.

✓ Futures contract

Common derivatives based on an agreement to buy or sell assets such as commodities like sugar or shares paid for at a later stage but with a set price. Futures are standardized to facilitate trading on the futures exchange where the detail of the underlying asset is dependent on the quality and quantity of the commodity.

✓ Options

Trading options on the derivatives markets gives traders the right to buy (CALL) or sell (PUT) an underlying asset at a specified price, on or before a certain date with no obligations this being the main difference between options and futures trading. Essentially, options are very similar to futures contracts. However, options are more flexible. This makes it preferable for many traders and investors.

✓ Futures vs. Options

The purpose of both futures and options is to allow people to lock in prices in advance, before the actual trade. This enables traders to protect themselves from the risk of unfavourable prices changes. However, with futures contracts, the buyers are obligated to pay the amount specified at the agreed price when the due date arrives. With options, the buyer can decide to back out of the contract. This is a major difference between the two securities. Also, most futures markets are liquid, creating narrow bid-ask spreads, while options do not always have sufficient liquidity, especially for options that will only expire well into the future. Futures provide greater stability for trades, but they are also more rigid. Options provide less stability, but they are also a lot less rigid. So, if you would like to have the option to back out of the trade, you should consider options. If not, then you should consider futures.

✓ Forward contracts

Financial instruments that are set up with more of an informal agreement and traded through a broker that offers traders the opportunity to buy and sell specified assets such as currencies. Here too a price is set and paid for on a future date.

✓ Swaps

Another common derivative used in a contract setting when trading are swaps, they allow both parties to exchange sequences of cash flows for a set amount of time. They are not exchanged or traded instruments but rather customized OTC contracts between two traders.

Why trade financial derivatives?

Originally derivatives were used to ensure there would be a harmonious balance in exchange rates for goods and services traded on a global scale. Traders found that with differences in currencies and accounting systems it would be easier for traders to find a common derivatives market.

Nowadays, the main reason for derivatives trading is for speculation and the purpose of hedging, as traders look to profit from the changing prices of the underlying assets, securities or indexes.

When a trader is speculating on derivatives, they can make a profit if their buy price is lower than the price of the underlying asset at the end of the futures contract. For example, if a person buys a futures contract for asset X, priced at $100, and if the price of asset X rises to $110 by the end of the contract, then the person made a profit of $10.

Derivatives come in several different forms, such as the kinds used for hedging or minimizing risk. For example, a trader may want to profit from a decrease in an assets selling price (sell position). When he inputs a derivative used as a hedge it allows the risk associated with the price of the underlying asset to be transferred between both parties involved in the contract being traded.

However, even though derivatives are used for speculation, they are also used for risk management. Many parties use derivatives to make sure that they do not suffer from unfavourable price movements in the near future.

For example, cereal manufacturer may buy wheat futures at a certain price to make sure that the company will be able to afford to purchase the wheat a few months down the line. This protects the cereal manufacturer from being caught in a position where it cannot afford to buy the wheat it needs if the price of wheat rises too much in one month’s time.

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