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WHAT ARE DERIVATIVES IN FINANCE

Derivatives are financial instruments that are set up to derive their value from underlying assets and aid in the management of risks. It is dependent upon the value of one or more underlying assets. Derivatives manage risks by insuring an investment against the probable fluctuations from the market prices.

It is termed as a financial contract since it involves an agreement between two parties. These parties, in turn, are acquainted with tasks whereby each of them is required to bring to the table. The contract may involve one party paying some amount of money, and in return, the other party covers the partner from risks of market fluctuation.

As illustrated earlier, derivatives help in deriving the value of market prices from underlying assets. This means that it is fundamental in gauging and determining the performance of various assets. Derivatives make use of underlying holdings like currency, stocks, bonds, interest rates, and commodities such as oil, gold, to mention a few.

The performance of the underlying assets determines the strength and performance of the derivative itself. The price is generally set on a mutual basis by both the buyers and sellers. With this relationship in mind, the sellers deliver the underlying assets to the buyers who in return pay for the underlying.

Aside from derivatives being an agreement between two parties, it usually has a set timeline that is defined and limited. Just like any other contract, the deal has a commencing date showing the beginning of the contract and a termination date signifying the expiration of the agreement between the two parties. This instrument is then used in calculating the payoffs and commissions, if any, from the beginning to the end of that period.

Forms of Derivative Contracts

Derivatives can be traded in two distinct financial markets. These are over the counter (OTC) contracts and exchange contracts. Over the counter contracts involve trade between two private parties, buyers and sellers that can be created anywhere else.

OTC contracts are unregulated and thus have a high tendency of suffering counterparty risks. This means that one party involved in the transaction may opt-out, posing a high risk to the contract owner.

The other form of derivatives is the exchange contracts. These contracts involve trades that are highly regulated and have prices standardized based on other assets. The transactions are well organized and formulated in a way that one cannot default while transacting. Exchange contracts also do not allow customization, and it has a back up of a clearinghouse.

Types of Financial Derivatives

Futures Contract derivatives

These contracts are based within two parties whereby they mutually agree on a present price that will be used in purchasing and delivering an asset at a future date. Transactions in a futures contract are strict on exchange contracts. This means that the trades offered are heavily regulated and standardized.

Future contract eliminates default risk in the sense that they act as a buyer to a seller and a seller to the buyer. These contracts ensure a well organized and standardized execution process of derivatives. It mandates both the buyers and sellers to oblige with their commitments of buying or selling of the underlying assets.

Forward Contract derivatives

These contracts are almost similar to futures. Forward involves an agreement between two or more parties to purchase and sell something at a future date. However, they use the price set at the present date. The only contrast from futures is that it involves over the counter to conduct its transactions.

Both buyers and sellers can customize their operations that are the terms to be used, the process of settling the trades, and the size to be transacted. However, this type of contract is likely to suffer counterparty risk. This entails that any party transacting within the contract may choose to default thus leading to a massive loss to the subsequent contract owner.

Financial derivatives in form of Swaps

Unlike the other types of derivatives, swaps are rendered to be more complicated. These types of contracts involve the exchange of one kind of cash flow with another. It allows traders to exchange a stream of cash flows. For instance, traders may use swaps in trading the currency exchange rate risks or use interest rate swaps in the case of variable and fixed rates loans.

Options

Options are more or less similar to futures. However, it only binds one party whereby they can let the other party determine the price at a later date. This date is usually the expiration of the contract. Options allow one party to choose whereas the other obliged party to buy or sell at a later date.

It is important to note that the party with the privilege to choose usually is required to pay premiums for this case. Options comprise of two forms namely;

  • Call Option; this allows the party a right but no obligation to buy anything at a later date.
  • Put Option; this allows the party a power but no obligation to sell anything at a later date.
  • In a nutshell, the use of derivatives plays an astonishing in the financial markets and mostly favors the market players in terms of managing risk. Feel free to contact us anytime if you seek any finance assignment help online and more info regarding the subject matter.

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