Obtaining financial literacy is a complicated process that entails a confident understanding of major financial concepts such as implementing money-saving strategies or creating investing roadmaps. It starts by acquiring basic knowledge of money matters and proceeds with research on more advanced financial tools. In this article, we will shed some light on the financial phenomenon of derivatives. Take a seat and enjoy the journey!
The article covers the following subjects:
What Are Financial Derivatives and How Do They Work?
Derivatives are contracts binding two parties that enter into a commitment to hand over a pre-agreed asset (or a pre-agreed derivative value) at the predetermined time and at the preset price. There are several types of underlying assets; they can be a financial asset, an index (a set of assets), a security, or even an interest rate.
The purchaser agrees to buy the specific asset on the predetermined date at the preset price. Notably, a derivative’s seller doesn’t have to be the owner of an underlying asset, as they can deliver on the contract by simply providing a purchaser with enough money to buy the agreed-upon asset at the specific price.
Let’s see how it works. Consider an American investor, Jeff, whose accounts are denominated in USD. Jeff buys shares of a European company via any of the operating EU exchanges for euros. From then onward, Jeff is vulnerable to the risk of a shift in the exchange rate. If the value of the US dollar against the euro rises, Jeff won’t profit from selling his shares of the European company.
If a seller gives a purchaser another derivative, it will offset the value of the first contract. That’s the main reason why derivative contracts are much easier to manage and trade than any type of underlying asset itself.
Derivatives can serve as effective financial instruments for the purposes of risk mitigation (hedging) or be used to speculate on possible risks for the sake of a commensurate reward.
Derivatives are usually traded on specialized exchanges, with some of them being traded off-exchange or over-the-counter (OTC).
Types and Classes of Derivatives
Derivative products can be separated into two classes: lock products (e.g., swaps) and options products (e.g., stock options).
- Lock products seal the deal between the corresponding parties from the outset to the negotiated terms during the life of the contract.
- Option products provide the holder with the right (without any obligations) to trade the underlying asset at a specific contract price on or before the option expires.
As we have already mentioned above, a derivative’s value is based on an asset; however, if you own a derivative, it doesn’t mean that you own the asset itself. The most common types of derivatives are futures, forwards, options, swaps, and warrants. Let’s learn a bit more about them.
Forwards vs. Futures
A forward, also known as a forward contract, is a customized private contract between two respective parties that is concluded in order to buy or sell an underlying asset at an agreed-upon price on a specific date. Forwards are frequently used for either hedging or speculation, though their non-uniform nature makes them a perfect tool tailored for hedging.
Forwards and futures have a lot in common, yet they are not perfectly alike. Both are based on the agreement to buy and sell some assets at the preset date, while their prices are derived from corresponding underlying assets.
A future, also known as a futures contract, is a likewise legal arrangement to buy or sell some assets at a predetermined price at a preset time in the future. However, a future is a standardized contract between a party and an exchange market that is characterized by fixed maturity dates and a day of expiration. Settlement for the futures contract takes place on a daily basis.
So, there is a significant difference between forwards and futures: a forward contract can be customized to a commodity, amount, date, and place of delivery; it always settles at the end of the expiration date and is an OTC derivative.
A warrant is a financial derivative that is issued by the company itself, providing its owner with the right (without any obligations) to trade securities — usually equities — at an agreed-upon price before the given expiration date. Warrants are rarely issued by a third party and are often OTC-traded. The prevailing price of an underlying security is called an exercise price or a strike price, and once a warrant is exercised, an underlying stock must be delivered.
There is a substantial difference between American and European warrants; the first ones can be completed at any moment on or before the expiration date, while the second type of warrant can only be exercised on the preset date of expiration.
- Call warrants are financial derivatives that give you the right to buy securities.
- Put warrants are financial derivatives that give you the right to sell securities.
An option shares some common traits with a warrant, as it also grants the purchaser the right (without any obligations) to buy or sell the underlying asset at a preset price. However, options don’t have to be issued by a company; they are typically contracts that are traded between two people without any business entity being involved. Another distinctive feature of an option contract is that the contracting parties are not required to honor the agreement to purchase or sell the asset. An option can be defined as “an opportunity,” while a future is always “an obligation.”
- Call options are financial derivatives that give you the right to buy stocks.
- Put options are financial derivatives that give you the right to sell stocks.
Swaps are the most widespread and tradable derivatives. A swap is a temporary exchange of assets (currency, securities, stocks, etc.) in trading on an exchange. The main feature of a swap is that the exchange is transitory; the parties to the transaction will have to return their assets to each other within the stated period of time. Swaps are used to drive out potential risks and enable investors to access the prevailing markets that operate under different jurisdictions.
Most swaps are either based on currencies or variable interest rates. Investors frequently use swaps as a hedging tool to alleviate potential risks.
For instance, a person can sell stocks in one country and then buy them in a foreign currency to hedge the existing currency risks. In this case, stocks are traded off-exchange.
Advantages of Derivatives Trading
Even if you have never worked with financial derivatives before, you can find tons of information that proves their significant impact on the modern finance market. Here are some essential benefits of derivatives that should be taken into account by aspiring investors:
Hedging is one of the most popular risk management tools employed to recoup losses by taking an opposite position in a related asset.
As the value of the derivative contract depends on the value of the underlying asset, such derivatives as options or forwards are used for hedging. The strategy of hedging provides an investor with some kind of insurance, as it alleviates the possible risks of unfavorable price movements in the corresponding asset. It’s similar to when you buy property damage insurance to hedge your house against robbery, fires, or other incidents.
In derivatives, it’s also possible to transfer risks from one party to another using swaps (as mentioned above).
Actual Value Determination
Derivatives are often used as an effective financial instrument to determine the actual value of the underlying asset. The spot prices of such commodity derivatives as futures can provide good insight into the current trade prices of the specific commodities and help determine the prevailing market price of an asset.
Increased Market Efficiency
Derivatives are generally considered powerful boosters of financial markets efficiency. Derivative contracts enable investors to easily replicate the payoff of their assets and avoid arbitrage opportunities due to the balance between the contract and the value of the underlying asset.
Access to Unavailable Markets
Using derivatives, organizations and companies can enter markets and assess assets that were unavailable to them before. Investors can obtain a more beneficial variable rate by commanding the advantages of interest rate swaps instead of falling back on direct borrowing.
Reduction in Transaction Costs
Since derivatives are widely regarded as effective risk management tools, the cost of trading in contracts is considerably lower than in other financial units.
Access to Information
Derivatives are about a rich load of data that can be used to evaluate the market sentiment properly. Even a person who doesn’t know much about finances can still make use of information provided by the current situation at the F&O (Futures and Options) market, thus getting insight into either short or long-term market price fluctuations.
Major Disadvantages of Derivatives
There are always two different sides to the same coin. Though the benefits of derivatives may seem appealing, every financial instrument has its peculiarities that can be put down as drawbacks. Unfortunately, derivative contracts make no exception.
For starters, the downsides of credit derivatives are often held up as one of the reasons the Global Financial Crisis of 2007-2008 occurred; devalued mortgage-backed securities and credit-default swaps caused the global financial collapse. What else should you know about the pain points of derivatives?
It’s sad, but it’s true: derivatives are potentially exposed to huge financial losses. The complicated nature of the contracts makes the evaluation process extremely sophisticated, and in individual cases, even impossible. Therefore, some derivatives bear a high inherent risk. It’s almost impossible to estimate a derivative’s actual value, as it’s usually based on the value of several underlying assets.
The main reason mortgage-backed securities turned out to be so deadly to the world economy is that no one knew how to value them – neither the programmers who created them nor experienced financial experts.
Derivatives can indeed serve as speculation tools; however, due to their unpredictable nature, they can be extremely risky and cause considerable losses.
Due diligence processes are a must for exchange-traded derivative contracts. Nevertheless, there are still some derivatives traded OTC that don’t integrate benchmarks for due diligence; therefore, they are exposed to counterparty default.
Such a peculiarity of derivatives as time-binding can also lead to potential losses. You can bet that petrol prices will increase soon, but you are not able to predict the exact date when it will happen – thus, you can’t profit from your assumptions, and you simply waste your time and resources.
Leverage is a financial technique that involves the use of borrowed funds. You have to be very careful when employing it. For instance, futures owners maintain their ownership by putting from 2% to 10% of the contract into a respective margin account. However, once the value of the underlying asset takes a beating, investors will have to add the required amount to the margin account to hold down the contracted percentage until the derivative expires or is offset. If the value of the asset keeps dropping, investors risk losing considerable amounts of money.
Where Are Derivatives Traded?
As we have already stated before, derivatives are usually traded either on exchange (ETD) or off-exchange (OTC).
The futures market operates in a physical location, meaning that it is centralized, unlike, for example, cryptocurrency exchanges. The Chicago Board of Trade and the Mercantile Exchange are the most prominent futures exchanges. Each futures contract is traded in a special enclosed place known as a “pit” or a “trading floor.”
Most derivatives are traded on exchanges. For instance, commodity futures are traded on a futures exchange, which is a special marketplace created to buy or sell various commodities. Members of the exchange, such as brokers and commercial traders, have to register with the NFA (National Futures Association) and the CFTC (Commodity Futures Trading Commission), which is a managing federal authority that regulates the futures markets. The CFTC ensures that the financial markets under its management function according to all applicable laws and regulations; it also has to prevent fraud and other abusive trading activities.
Like other derivatives, options contracts are traded on exchanges that serve as intermediaries between buyers and sellers. The CBOE (Chicago Board Options Exchange) is the largest and one of the most reliable options marketplaces in the world. Options trading is regulated by the SEC (Securities and Exchange Commission), the main function of which is to monitor the existing markets and safeguard them against the violation of rules or any kind of malfunction.
- Regulations of financial activities are determined either by a product or an exchange. For instance, currencies are usually traded OTC, meaning the trade is made between brokers and financial institutions (e.g., banks). Two legal entities can also agree to exchange currencies at a specific rate at a predetermined date. Financial authorities and individual brokers are both regulated by the SEC. Transactions conducted via OTC might be risky since they are not controlled by any central marketplace.
CFD trading is a financial derivative product that enables traders to speculate on the rise and fall of a price of fast-moving global financial markets, including currencies, stocks, indices, commodities, etc.
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Are Financial Derivatives Worth Your Attention?
Derivatives were once described as weapons of mass destruction, and there is a good deal of truth in this utterance. A derivative contract can be very beneficial and present your legitimate interest if you know how to employ them properly. Risk-averse investors usually consider these financial instruments inherently evil; there are, however, multiple ways you can manage the unique potential of derivatives to enhance the functionality of your investment strategy.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.