What are Derivatives?

6 min readApr 24, 2023

Types, Considerations, Pros, and Cons

In this article we will go into the topic of Derivatives (Financial contracts), including the definition of derivatives, the various types of derivatives, and their uses for hedging, speculation, and arbitrage.

The article covers futures, forwards, options, and swaps, highlighting the differences between each type and its unique characteristics. It also discusses how derivatives are used to manage risks and speculate on price movements, along with the potential benefits and risks associated with them.

Understanding Derivatives

A derivative is a financial contract or product whose value is derived from an underlying asset, such as a stock, bond, currency, or commodity. Derivative financial products derive their value from an underlying asset. The underlying asset can be anything from financial assets such as shares, bonds, and foreign exchange to physical assets such as metals, energy resources, and agricultural products.

The value of the derivative is based on the value of the underlying asset, and changes in the value of the underlying asset will affect the value of the derivative.

Types of Derivatives

Derivatives come in various forms, such as futures, forwards, options, and swaps. Each type of derivative has its unique characteristics and serves different purposes.

Futures and forwards are both contracts that obligate the parties involved to buy or sell an underlying asset at a future date at a predetermined price. The difference between futures and forwards is that futures are standardized contracts traded on an exchange, while forwards are customized contracts traded over the counter (OTC) between two parties.

Future Contracts:

Futures contracts are traded on exchanges and are standardized in terms of their contract size, expiration date, and the underlying asset. The exchange acts as a mediator, ensuring that both parties fulfill their obligations. Futures contracts are used primarily for hedging and speculating purposes. Hedgers use futures contracts to lock in a price for a commodity or asset to protect against price volatility. Speculators use futures contracts to profit from changes in the price of the underlying asset.

Forward Contracts:

Forwards contracts, on the other hand, are customized contracts between two parties. They are not traded on exchanges, and the terms of the contract can be tailored to the specific needs of the parties involved. Forwards contracts are used primarily for hedging purposes, particularly in the case of non-standardized assets.

Options:

Contracts known as options grant the buyer the right, but not the duty, to purchase or sell an underlying asset at a fixed price on or before a particular date. The right to exercise an option is purchased by the buyer of the option by paying a premium to the seller. Options may be used for speculative or hedging purposes.

Call options and put options are the two different forms of options. When purchasing a call option, the buyer has the right to purchase the underlying asset at a predetermined price, whilst purchasing to offer the underlying asset for sale at a specified price. The seller of an option, also known as the option writer, is obligated to sell or buy the underlying asset if the buyer exercises their option.

Swaps

Swaps are contracts between two parties to exchange cash flows based on a prearranged formula. The risks brought on by interest rates, currency exchange rates, and commodity prices are managed through the use of swaps. Swaps come in many different varieties, such as interest rate swaps, currency swaps, and commodity swaps.

Interest rate swaps involve the exchange of fixed and floating interest rate payments, while currency swaps involve the exchange of fixed and floating currency payments. In commodity swaps, cash flows dependent on the price of a certain commodity are exchanged. Swaps are traded over the counter and can be customized to the needs of the parties involved.

Hedging

Derivatives can be used for a variety of purposes such as hedging, speculation, and arbitrage. Hedging is the practice of using derivatives to protect against potential losses from adverse price movements in the underlying asset. For example, a farmer may use a futures contract to lock in a price for their crops to protect against price volatility.

Arbitrage

Arbitrage is the practice of taking advantage of price discrepancies between different markets or instruments. For example, an investor may buy an asset in one market and sell it in another market where the price is higher to make a profit.

Derivatives can also be used to create complex financial instruments such as structured products and collateralized debt obligations (CDOs). These products can be difficult to understand and associated with higher risk levels.

One of the benefits of derivatives is that they can provide liquidity to markets by allowing investors to take positions in assets without actually owning them. This can increase the efficiency of markets and provide opportunities for investors to profit.

Derivatives play an essential role in modern finance by allowing market participants to manage risk and speculate on price movements. They provide a way for investors to gain exposure to underlying assets without actually owning them.

However, derivatives are also associated with several risks, including counterparty risk, market risk, and liquidity risk. Counterparty risk is the risk that the other party in the contract may not fulfill their obligations. Market risk is the risk that the value of the derivative may change due to changes in the underlying asset’s price. Liquidity risk is the risk that the product may not be easily tradable, making it difficult to exit a position.

Conclusion

The value of a derivative is determined by the price of the underlying asset, as well as other factors such as interest rates, volatility, and time to expiration. There are several types of derivatives, including futures, forwards, options, and swaps, each serving a specific purpose.

Derivatives allow investors to manage risk and speculate on price movements, but they are also associated with counterparty risk. As with any financial instrument, it is essential to understand the risks associated with derivatives before investing.

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Do your research and Happy Investing!

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