Derivatives are financial instruments used to manage one’s exposure to today’s volatile markets. A derivative product’s value depends upon and is derived from an underlying instrument, such as commodities, interest rates, indices or stocks.
In other words, a derivative is a financial contract with a value linked to the expected future price movements of an underlying asset it is linked. It is used as a tool for hedging, speculating and arbitraging.
Forward contract forms the oldest type of derivatives market. Forward by definition is an agreement to buy and sell a specified security at a specified price to be delivered at the maturity date in the future. The agreement is privately arranged to fulfill the need of both contracting parties, a buyer and seller. If one party intends to close out the contract it must be at the consent of the other party. Therefore a forward contract is technically referred to as a privately negotiated agreement.
Futures are traded on a futures exchange and represent an obligation to buy or sell a specified underlying instrument on a specified date (the delivery date or final settlement date) in the future at a specified price (the futures price). The settlement price is the price of the underlying asset on the delivery date. Both parties to a futures contract are legally bound to fulfill the contract on the delivery date. If the holder of a futures position wishes to exit their obligation before the delivery date, they must offset it either by selling a long position or buying back a short position. Such an action effectively closes the futures position and its contractual obligations.
Future market develops as a result of insufficient trading requirement of forward transactions. Either party justifies this because forward as a private agreement does not guarantee the fulfillment of the contract. A third party is required to act as a guarantor, namely the clearing house. It serves as a buyer for every seller and vice versa.
An option is a financial instrument that gives the holder the right to engage in a future transaction on an underlying security or futures contract. The holder is under no obligation to exercise this right. There are two main types of option. A call option gives the holder the right to purchase a specified quantity of a security at a fixed price (the strike price) on or before the specified expiration date. A put option gives the holder the right to sell. If the holder chooses to exercise the option, the party who sold, or wrote, the option is obliged to fulfill the terms of the contract.
Since forward and futures trading obligates both buyer and seller to fulfill their contracts, a third form of derivatives is introduced that provides a right to one party and obligation to the other party. Options trading are a contract that gives a right without obligation to the buyer, while the seller has an obligation if requested by the buyer to buy or sell at a specified security at specified price and time.
A swap is a derivative in which two parties agree to exchange a set of cash flows (or leg) for another set. A notional principal amount is used to calculate each cash flow; these are rarely exchanged by the parties. A swap is usually used to hedge a risk, such as an interest-rate risk, or to speculate on a price change. It may also be used to access an underlying asset in order to earn a profit or loss from any change in price while avoiding posting the notional amount in cash or collateral.
Below are some of the uses of derivatives like futures and options, as listed by John C. Hull in his 1999 book titled ‘Options, Futures and Other Derivatives’.
- Derivatives are very good risk management tools and are mainly used to hedge risks that a trader is routinely exposed to. Derivative instruments offer the trader, the option of passing on some of the risk that he’s bearing over to another party. He either takes on another risk in return or makes a cash payment in exchange for the risk transfer.
- Derivative instruments like forwards and futures play a key role in giving directions to the market prices of the future. Forwards and futures prices are good reflectors of the price directions as well as the expected change in the future prices of the underlying asset.
- Derivatives offer the traders an option to change the nature of their liabilities and exchange the risks associated with some of their unwanted liabilities with some more bearable ones.
- Derivatives can be used to make arbitrage profits. Arbitrage profit opportunities are those opportunities that allow for risk-free, zero net investment profits, by capitalizing on price differentials on the same commodity in different markets. The intention is to buy low and sell high in two different markets and pocket the differential profits.
- Derivatives allow for large portfolio position changes without incurring the buying and selling transaction costs.
The use of derivatives means that some financial risks can be transferred to other parties who are more willing or better suited to take or manage those risks and can thus be a useful tool for risk management.
Purchasing derivatives can be a safer choice if there is a possibility of a looming bear market as they are hedged, unlike equities.
Buying now at a future price can be cheaper than buying at market price in the future, bearing in mind that the spot price could be less expensive. A long call option requires no obligation when it is due.
If the market changes dramatically, it is possible to lose financially if the derivatives are being used as a speculative instrument.
If you hold the put option on a derivative, you are obliged to adhere to it if the holder of the call chooses to exercise their right to sell or buy.
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