What is Financial derivatives?

Financial derivatives are the contracts that derive their value from underlying assets. There are broadly four types of financial derivatives including swaps, futures, forwards and options.

Table of Contents

• What is financial derivatives?
• Advantages of using derivatives
• Use of financial derivatives
• How to trade in the derivative market?
• Types of financial derivatives
  • Futures
  • Swaps
  • Forward Contracts
  • Options
• Limitation of derivatives

What is financial derivatives?

Financial derivatives are those financial instruments or contracts whose value has been derived from underlying assets. These are set between two or more parties and can be traded over the counter or in an exchange. 

Traders purchase derivatives through the brokerage. Their prices are derived from fluctuations in the prices of underlying assets such as stocks, commodities, bonds, etc. There are different types of derivatives including futures, options, forwards, and swaps. 

Advantages of Derivatives

The derivatives contract are used by traders to:`

1. Limit your losses on investments. 
2. Fix the commodity price to minimize losses.
3. Hedge against price volatility to create a balanced exchange rate for assets.

Why use Financial Derivatives?

The main objective of a derivative is to speculate on the future prices of financial assets in the future. Financial derivatives are used for trading assets. These securities are used for risk management, hedging, and speculation. They are the leveraged instruments that increase the potential risk and thus, reward. Derivatives can move risk from risk averse to risk seekers. These are used by traders to access certain markets and to trade different assets. 

Trading in the Derivative Market

To trade in the derivative market, you will need a trading account. In the derivative market, trading is done through exchanges and over-the-counter methods. Future and options are the derivatives that are exchange-traded products. Forward and swaps are traded over the counter. These contracts are customizable for the convenience of both parties.

Types of Financial Derivatives

There are different types of derivatives with broadly two products: Lock and options. Futures, swaps, and forwards are the lock products that bind parties through agreed-upon terms over the contract life. Option products offer the holder the opportunity to trade security at a specific price before the expiration date of the product. Let us now discuss these products in detail.

1. Future Contracts

Futures indicate an agreement between parties for the purchase and delivery of assets at an agreed-upon price in the future. The parties have the obligation to fulfill the commitment of trading the asset. These contracts are used to hedge risk or for speculating on the price of the underlying assets. 

If the accepting party no longer wants the delivery of the product agreed upon through the contract, they can sell it before expiration and keep the profit. Speculators can close their obligation of either purchasing or delivering a commodity before the expiration of the contract with an offsetting contract. They can do so with mutual agreement. 

2. Swaps

Swap is a contract between two parties that agree to exchange cash flow or liabilities from two different financial institutions. These are over-the-counter derivative products and are not traded over exchanges. Swaps occur between financial institutions and businesses as per their convenience. Swaps are used to hedge currency risk and interest rate risk. There are different types of swaps that we will be discussing in this section. 

1. Interest Rate Swaps

This type of swap allows counterparties to exchange fixed and floating cash flows on interest-bearing investments. Investors can switch the cash flow as per their requirement using interest rate swaps. Here, instead of the principal amount, the interest payments are exchanged on ‘notional principal’. It converts one interest rate basis to another rate basis to fixed interest. 

2. Currency Swaps

In this agreement, the parties exchange the loan amount and interest in one currency for another currency. At the inception of currency swap, principal amounts are exchanged at a spot rate. During the length of a currency swap, each party has to pay interest on the swapped principal loan amount. Once the swap ends, principal amounts are swapped back at either the pre-agreed rate or the prevailing spot rate. Through currency swaps, companies can obtain foreign currency loans at better interest rates than directly through the foreign market.

Currency swap or cross-currency swap refers to the exchange of interest payments at fixed dates through contract life. It also includes the exchange of principal from one currency to another. At present, swaps are performed to hedge long-term investments and to change the exposure of the interest rate of two parties. Those companies that do business outside the country use this swap to get better loan rates in local currency than borrowing money from banks in the country. 

Learn about forex trading

3. Commodity Swaps

This financial derivative is a contract that occurs among companies that use raw materials for producing finished goods and products. The two parties agree to exchange the cash flow that is dependent on the price of an underlying commodity. Commodity producers and consumers can lock in the set price for a given commodity through commodity swaps. 

These are not traded on an exchange but are customized deals executed outside of the formal exchange without the supervision of an exchange regulator. Commodity swaps limit the risk for a given party within the swap. The party that is interested to hedge its risk against the volatility of a commodity price enters this swap. This party accepts to pay or receive an agreed price throughout the agreement.

4. Credit Default Swaps

It is a financial derivative that allows investors to swap credit risk with another investor’s risk. These contracts are maintained through an ongoing premium payment that is similar to the regular premiums due to the insurance policy. Lenders purchase these swaps from those investors who agree to pay the lender in cases when the borrower defaults on its obligations. 

5. Zero-Coupon Swaps

This swap allows flexibility to one of the parties in swap transactions. The fixed rate of the swap is paid in one lump sum once the contract reaches maturity. Since the payment is in lump sum, valuing zero-coupon swap involves valuing present value of cash flows through the implied interest rate of zero-coupon bond.

3. Forward Contracts

Forward Contracts are agreed upon between two parties to buy and sell assets at pre-agreed prices on a future date. They can be used for both hedging and speculation since the forward contract has non-standardized nature. These are customizable financial derivatives that can be tailored to a particular commodity, price, and delivery date. They are over-the-counter instruments that are not traded on exchanges. The settlement of forward contract can be done on either a cash or delivery basis. 

4. Options

Options are another type of financial derivative that allows its bearer to buy or sell underlying assets before the expiry of the contract. These financial derivatives enhance the investor’s portfolio since options offer add-on leverage and protection. The value of options is dependent on other asset prices. If a buyer wants to own an option, he will have to pay a premium. There are two main types of options.

1. Call: Through the call option, the buyer holds the right to buy the underlying asset at strike price mentioned in the option contract. It is, however, not an obligation. Based on the observation, investors make a decision to either sell or buy calls. If the investor believes that the price of the underlying asset will increase, he buys the call. If the investor believes that the price will decrease, then he will sell the call. In the call option, the buyer has to pay the full amount of the option premium while entering the contract. 
2. Put: These options allow buyers to sell the underlying asset at strike price as mentioned in the option contract. Similar to the put option, there is no obligation. The seller of put option is obligated to buy the asset when put buyer exercise the option. Based on the observation, investors make the decision to either buy or sell puts. If the price of asset increases, the investor sells the put. If the price of underlying asset decreases, the investor buys the put. 

Limitations of Financial Derivatives

They do have certain limitations as well. Financial derivatives are difficult to value since their prices are based on other assets. These financial contracts are sensitive to several factors making it difficult to match the contract’s value with that of the asset. These factors include the following:

• Cost of holding underlying assets
• Changes in the amount of time to expiration
• Vulnerable to the market sentiment which causes the derivative to have no intrinsic value  
• Sensitive to demand and supply
• Riskier to trade in due to anticipation of the price of the security

Conclusion

Hope you have now understood what is financial derivatives and how they are used by traders and investors for better results. Based on your risk tolerance, capacity, and requirement, you can choose one that fulfills all your future needs.