A financial derivative is a tradable product or contract that ‘derives’ its value from an underlying asset. The underlying asset can be stocks, currencies, commodities, indices, and even interest rates. Derivatives were originally designed to help investors eliminate exchange rate risks, but their utility has grown over the years to help investors not only mitigate various types of risks but also to access more market opportunities. Derivatives are now attractive to many types of investors because they help them to remain exposed to price changes of different financial assets without actually owning them. AICTE Approved B-school in Bangalore
Financial derivatives contracts are usually settled by net payments of cash. This often occurs before maturity for exchange-traded contracts such as commodity futures. Cash settlement is a logical consequence of the use of financial derivatives to trade risk independently of ownership of an underlying item. However, some financial derivative contracts, particularly involving foreign currency, are associated with transactions in the underlying item.
Types of Derivatives:
The most common types of derivative contracts are futures, options, and CFDs. These are offered either OTC (Over-the-counter) or via an Exchange. The derivative’s value is affected by the performance of the underlying asset and also the contract conditions.
The more common derivatives used in online trading are:
- CFDs- CFDs enable you to speculate on the increase or decrease in the price of global instruments like shares, currencies, indices, and commodities. When you trade CFDs, you are effectively taking a contract, rather than taking hold of the underlying asset. That means you will be speculating on the price movement, rather than buying the actual asset. With CFDs, you can trade both ways, on both rising or falling markets. That is a big benefit of trading CFDs, rather than buying stocks, for instance.
- Options- Trading options on the derivatives markets give traders the right to buy (CALL) or sell (put) an underlying asset at a specified price, on or before a certain date. The holder has no obligation to buy the underlying asset. This is the main difference between Options and Futures.
- 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 unfavorable price 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 are set up with more of an informal agreement and traded through a broker that offers traders the opportunity to buy and sell specific assets such as currencies. Here too a price is set and paid for on a future date. This contract can also be renegotiated, so extended or closed early for a premium.
- Swaps- Swaps are customized OTC contracts between two traders. These aren’t usually traded by retail investors and are not traded over exchanges. A common example of a swap is on interest rates. Swaps are when two parties exchange cash flows or liabilities for two different securities, over a set period of time.
Advantages of Derivatives
Unsurprisingly, derivatives exert a significant impact on modern finance because they provide numerous advantages to the financial markets: Best MBA college in Bangalore
- Hedging risk exposure- Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.
- Underlying asset price determination- Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.
- Market efficiency- It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.
- Access to unavailable assets or markets- Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.
Disadvantages of Derivatives
Despite the benefits that derivatives bring to the financial markets, financial instruments come with some significant drawbacks. The drawbacks resulted in disastrous consequences during the Global Financial Crisis of 2007-2008. The rapid devaluation of mortgage-backed securities and credit-default swaps led to the collapse of financial institutions and securities around the world. PGDM course in Bangalore
- High risk- The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.
- Speculative features- Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.
- Counterparty risk- Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counterparty default.
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