A financial derivative is a contract that is used to disburse profits among investors. It is also used to award employees with stock options. The value of this contract depends on the value of the asset that lies against it. This asset could be a financial security bond, commodity security, foreign currency, or interest rate.
So, its value is variable and it can be used to earn a profit by trading it from one market to another. It also helps reduce an investment's financial risk.
Financial Derivatives – An overview
Derivative financial instruments are contracts with security whose value depends on the value of the underlying asset. These assets could be one or more in number. The assets in financial derivatives can be stocks, commodities, bonds, market indexes, currencies, interest rates, or indices.
Types of Derivative Instruments
The most common type of derivative instruments include:
It is an agreement between two parties to sell their asset on a predetermined date in the future. The forward contracts have a high chance of counterparty risk. It is also customized. The agreement size depends on the contract term.
It is an agreement made by two parties to purchase or sell the underlying instrument at a fixed price on a future date. They do not allow the buyer and the seller to meet and enter into an agreement. The deal gets fixed through exchange mode. Here counterparty risk is extremely low.
Swap contracts are one of the most complex contracts. In swap contracts, there is a private agreement between both the parties. Notably, the parties in agreement exchange cash in the future as per a predetermined formula. The underlying security is the currency or interest rate. Both the parties are protected from many big risks.
Option contracts do not need any compulsory discharging on a specified date. They provide a right but not the commitment for buying or selling the underlying instrument. It consists of two options - the call option and the put option.
Role of derivatives in markets and trading
Financial derivatives serve many direct and indirect functions in the financial market and trading:
(a) It helps in earning secure profits.
(b) It gives investors an advantage of arbitrage because you can buy an asset at one price and then sell it at a higher price in other markets. The buyer gets a trading advantage in different markets.
(c) It helps in getting an extra benefit from two markets.
(d) It is an instrument to protect certain investments from market volatility. It helps in shielding your assets against stock price falls.
(e) Derivatives are used to transfer risk and level out a portfolio.
(f) They are also used to reward investors.
How are derivatives used?
Derivatives are primarily used in three ways:
(a) As stock options: Derivatives can be used as a part of a compensation package for employees. It is not a common practice, but it is presently being used in some companies. Employees Receive Stock Options (ESOPs), which allow them to own a fixed amount of the company’s stock. These ESOPs cannot be traded in the market, but they can be exchanged for public trading shares on a stock exchange.
(b) As commodities: Almost all natural resources or raw materials like crude oil, precious metals, and crops are purchased using derivative contracts. Production and extraction of natural resources industrially require a large investment of both time and money. These two things are saved by using derivative contracts
(c) As speculative assets: Financial organizations like banks or insurance companies make a lot of money by returns on investments. They need a highly diversified portfolio for survival in the market. They create and trade derivatives through a financial strategy that helps them earn revenue through speculation. But, the risk is not evenly distributed. That means there are some assets that the investor needs to rely on more than others. With the help of trading derivatives, investors hedge their bets and protect themselves against risks of the derivatives market.
Advantages of financial derivatives
Derivatives have an important role in modern finance. They provide many advantages to financial markets:
Hedge the risk exposure
The significance of derivatives depends upon the value of their underlying asset. These derivative contracts are mainly helpful in hedging risks. If an investor purchases a derivative contract that has a value in inverse variation with the value of the asset owned by investors, then profits in the derivative contract counterbalance the loss in the asset that is underlying.
Determines the price of the underlying asset
Derivatives help in determining the price of the underlying asset. The spot prices of the future contracts serve to approximate the price of the commodity.
Increase the efficiency of the market
Derivatives increase the efficiency of financial markets by replicating the asset's payoff. Prices of the underlying asset and the lined derivative are, therefore, in equilibrium to avoid any arbitrage opportunities.
Access to unreachable assets or markets
Derivatives help organizations to gain access to assets or markets that are normally unreachable. By using the swapping of interest rates, a company may get a favorable rate of interest as compared to interest rates from borrowing directly.
Disadvantages of financial derivatives
As financial instruments, derivatives have some notable drawbacks. It also caused the global recession of 2007-2008. The devaluation of mortgage-backed securities was rapid. The credit-default swaps also crashed financial institutions and securities all across the globe. So, derivatives are not entirely risk-proof.
Derivatives carry a high risk
Derivatives are highly volatile, so they incur huge losses also. The complex design of these derivative contracts makes the valuation impossible in some cases. It is extremely complicated to calculate the value. So naturally, it carries a high risk.
High speculation involved
Derivatives are speculative tools. Derivatives are extremely risky and unpredictable. So, there is high speculation about it and it may lead to big losses.
Derivatives are usually traded on the exchanges. They generally undergo a thorough checking process. But, some derivative contracts which are traded over the counter have no set standards. Thus, there is a chance that the counterparty may default.
Risks involved in derivatives
Derivatives are used to reduce risk. This is the reason why traders prefer it. But in reality, it is equally risky as any other market tool. But, what are these risks? Come let us understand them in detail.
Risk of market
Market risk is an ordinary risk that is common in any of the investment options that are available in the market. If the market undergoes a bear run, then there is a chance that the investment might also lose its value. Risks include economic recessions, interest rate shifts, or other external factors. Before you begin trading derivatives, you need to research thoroughly and check whether the investment will be profitable in the future or not, as the derivatives market can be quite volatile.
There is always a chance that the derivative might go bankrupt and it will affect the financial health of the party or the counterparty. Also, there are many risks that the counterparty has to bear like a risk in credit, a legal risk, or a risk of settlement. So, there is also a risk that one of the parties might not keep up the commitment.
As soon as the date is due, the contract will expire. If the investment does not become profitable in that specific period, this means you will lose money. So, the derivative contract needs to perform within the time limit that has been specified.
This is dependent on the market conditions. There is always a chance that the derivative contract might change its value owing to the market condition. If it rises high, then you will earn a profit. But, if the market goes down, then you are bound to lose money. Before you begin trading in derivatives, you must learn how to manage such risks effectively. The market always goes up and comes down. You need to be an extremely vigilant trader in this market.
Finance professionals working in trading and asset management need to understand derivatives to help their clients build a profitable portfolio. At the same time, they need to hedge the risk as much as they can.
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