Derivative (financial)

3 key takeaways

• Financial derivatives derive their value from underlying assets such as stocks, bonds, commodities, currencies, interest rates, or market indexes.
• They are used for hedging risk, speculating on price movements, and increasing leverage in investment strategies.
• Derivatives can be complex and carry significant risk, making them suitable primarily for knowledgeable investors and institutions.

What is a derivative (financial)?

A financial derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index, or security. The primary purpose of derivatives is to transfer risk between parties, speculate on future price movements, or hedge against potential price volatility of the underlying assets. The main types of derivatives include futures, options, forwards, and swaps.

Types of financial derivatives

• Futures: A standardized contract to buy or sell an asset at a predetermined price at a specified time in the future. Futures are traded on exchanges and are commonly used for commodities, currencies, and financial instruments.
• Options: A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price before or on a certain date. There are two types of options: calls (the right to buy) and puts (the right to sell).
• Forwards: Similar to futures, but these contracts are customized agreements between two parties to buy or sell an asset at a specified price on a future date. Forwards are traded over-the-counter (OTC) rather than on exchanges.
• Swaps: Contracts in which two parties agree to exchange cash flows or other financial instruments. Common types include interest rate swaps, currency swaps, and commodity swaps.

Uses of financial derivatives

• Hedging: Investors and companies use derivatives to hedge against risks associated with price fluctuations in the underlying assets. For example, an airline company might use fuel futures to lock in fuel prices and protect against future price increases.
• Speculation: Traders use derivatives to speculate on the future price movements of assets. This can lead to significant profits if the speculation is correct, but it also involves substantial risk.
• Leverage: Derivatives allow investors to gain exposure to the price movements of an underlying asset without having to invest the full amount. This leverage can amplify both gains and losses.
• Arbitrage: Traders use derivatives to take advantage of price discrepancies between markets. By simultaneously buying and selling related instruments, they can lock in risk-free profits.

Risks associated with derivatives

• Market Risk: The value of derivatives can fluctuate significantly due to changes in the price of the underlying asset, leading to potential losses.
• Credit Risk: In OTC derivatives, there is a risk that one party may default on the contract.
• Liquidity Risk: Some derivatives may be difficult to buy or sell quickly without impacting their price.
• Complexity: Derivatives can be complex and difficult to understand, leading to potential misuse or misunderstanding by investors.

Examples and applications

Example:

A farmer anticipates that the price of wheat might fall by the time of harvest. To hedge against this risk, the farmer enters into a futures contract to sell wheat at a fixed price at harvest time. If the price of wheat does indeed fall, the futures contract protects the farmer from losses by ensuring they can sell their wheat at the agreed-upon price.

Applications:

• Risk Management: Companies use derivatives to hedge against various risks, such as currency risk, interest rate risk, and commodity price risk.
• Investment Strategies: Hedge funds and institutional investors use derivatives to enhance returns, manage risk, and implement complex investment strategies.
• Pricing and Valuation: Derivatives are used in financial modeling and valuation to price complex securities and manage portfolios.

Related topics

For further reading, consider exploring the following topics:

• Hedging: Strategies used to offset potential losses in investments by taking opposite positions in related assets.
• Speculation: The act of trading in financial instruments, such as stocks, bonds, and derivatives, with the hope of making a profit.
• Leverage: The use of borrowed capital or financial instruments to increase the potential return of an investment.
• Arbitrage: The simultaneous purchase and sale of an asset in different markets to exploit price differences.

Understanding financial derivatives is crucial for investors, traders, and financial professionals to effectively manage risk, implement strategic investments, and navigate the complexities of financial markets.