What Are Financial Derivatives?

What is a derivative?

A financial instrument based on another asset is known as a derivative. Stock options and commodities futures are two of the most common examples of derivatives, and you’ve definitely heard of them but aren’t sure how they operate.
Derivatives allow consumers the option — but not the duty — to acquire or sell an underlying asset at a later date. The underlying asset and the period until the contract expires determine the derivative’s value.

How Financial Derivatives Work

Financial derivatives are financial products whose value is determined by one or more underlying financial assets, such as stocks, bonds, commodities, currencies, or interest rates.

Investors engage in contracts with stated terms, such as the period of the contract and the consequent values and definitions of the underlying assets, to purchase and sell derivatives.

Futures, options, swaps, and forwards are examples of financial derivatives. Futures and options are often traded on the CME, which is one of the world’s major derivatives marketplaces. Swaps and forwards are traded on an over-the-counter (OTC).

Derivative Regulations

The SEC and the CFTC regulate financial derivatives in the United States. FINRA regulates the parties engaged in financial derivative contracts.

Ways Derivatives Are Used

Derivatives are rarely used as part of a long-term buy-and-hold strategy due to their complexity.

Derivatives are used for:

Hedging: To limit losses, an investor can use derivatives. For example, if an investor is concerned about a rapid drop in the price of security they own, they can buy put options, which can benefit if the price of the security drops, thereby offsetting the loss of the other asset.

Leverage: Financial leverage may be achieved by using derivatives to boost the returns of an underlying asset or index.

Speculation: If an investor feels the price of an asset will move dramatically in one way, they can utilize a derivative to profit from the projected price movement.

Access to complex assets:  Financial derivatives can give an investor indirect access to assets or markets that would be difficult to access otherwise.

4 Derivative Investment Types

The four main types of derivatives are futures, options, forwards, and swaps. Common types of underlying assets within these derivative types include stocks, bonds, commodities, bonds, interest rates, currencies, and cryptocurrency.

The four main types of derivatives are:

  • Futures
    Futures are financial derivatives that include a contract between two parties to exchange an asset at a certain price and date in the future. Regardless of the prevailing market price at the time the contract expires, the buyer of the futures contract must purchase (and the seller must sell) the specified asset at the price indicated in the contract
  • Options
    Options are financial derivatives that involve a contract that provides the buyer the right to purchase or sell the underlying asset but not the obligation to do so.
    The call option and the put option are the two types of options available.
    – A call option allows an investor to purchase a stock at a specific price by a specific date.
    – A put option allows an investor to sell a stock at a specific price by a specific date.
  • Forwards
    Forwards, also known as forward contracts are financial derivatives that involve two parties entering into a tailored contract to purchase or sell an asset at a specific price on a specific future date.
  • Swaps
    Swaps are financial derivatives that include a contract that permits two parties to exchange cash flows for a certain period of time. An interest rate, currency exchange rates, or the price of a stock or commodity may all influence cash flows.

Advantages

  • Hedging: Derivatives can be used by investors to hedge an existing asset position. The derivative contract’s earnings may be used to cover losses in the underlying asset.
  • Financial leverage: It’s possible to utilize it to boost the returns of an underlying asset like a commodity or an index.
  • Access to unavailable markets: Derivatives can provide investors access to assets or markets that would otherwise be difficult to reach.

Disadvantages

  • Complexity: Derivatives and associated methods can be difficult to grasp for many investors since they frequently need extensive investment expertise and understanding.
  • Risk: Derivatives can expose investors to losses that are greater than those incurred by the underlying asset.

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