Derivatives in Finance

What are Derivatives in Finance?

Derivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc.

Most Common Derivatives in Finance

The following are the top 4 types of derivativesTypes Of DerivativesA derivative is a financial instrument whose structure of payoff is derived from the value of the underlying assets. The three types of derivatives are forward contract, futures contract, and options.read more in finance.

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# 1- Future

A futures derivative contract in finance is an agreement between two parties to buy/sell the commodity or financial instrument at a predetermined price on a specified date.

#2 – Forward

A forward contract works in the same way as the futures, the only difference being, it is traded over the counter. So there is a benefit of customization.

#3 – Option

Options in financeOptions In FinanceOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.read more also work on the same principle. The however biggest advantage of options is that they give the buyer a right and not an obligation to buy or sell an asset, unlike other agreements where exchanging is an obligation.

#4 – Swap

A swap is a derivative contractSwap Is A Derivative ContractSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more in finance where the buyer and seller settle the cash flows on predetermined dates.

There are investors/investment managers in the market who are called the market makersMarket MakersMarket makers are the financial institution and investment banks which ensures enough amount of liquidity in the market by maintaining enough trading volume in the market so that trading can be done without any problem.read more. They maintain the bid and offer prices in a given security and stand ready to buy or sell lots of those securities at quoted prices.

Use of Derivatives in Finance

#1 – Forward Contract

Suppose a company from the United States is going to receive payment of €15M in 3 months. The company is worried that the euro will depreciate and is thinking of using a forward contractForward ContractA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price).read more to hedge the risk. This effectively means they fear they will receive less $ when they go out to exchange their € in the market. Therefore by using a forward contract, the company can sell the euro right now at a predetermined overhead ratePredetermined Overhead RatePredetermined overhead rate is the distribution of expected manufacturing cost to the presumed units of machine-hours, direct labour hours, direct material, etc., for acquiring the per-unit expense before every accounting period.read more and avoid the risk of receiving less $.

#2 – Future Contract

To keep it simple and clear, the same example as above can be taken to explain the futures contract. However, the futures contract has some major Differences as compared to forwards. Futures are Exchange-traded. Therefore they are governed and regulated by the exchange. Unlike forwards, which can be customized and structured as per the parties’ needs. Which is why there is much less credit, counterparty risk in forwards as they are designed according to the parties’ needs.

#3 – Options

An investor has $10,000 to invest; he believes that the price of stock X will increase in a month’s time. The current price is $30; in order to speculate, the investor can buy a 1-month call option with a strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more of let’s say $35. He could simply pay the premium and go long call on this particular stock instead of buying the shares. The mechanism of our option is exactly the opposite of a call.

#4 – Swaps

Let’s say a company wants to borrow € 1,000,000 at a fixed rate in the market but ends up buying at the floating rate due to some research-based factors and comparative advantage. Another company in the market wants to buy € 1,000,000 at the floating rate but ends up buying at a fixed rate due to some internal constraints or simply because of low ratings. This is where the market for swap is created. Both the companies can enter into a swap agreement promising to pay each other their agreed obligation.

Calculation Mechanism of Derivatives Instruments in Finance

  • The payoff for a forward derivative contract in finance is calculated as the difference between the spot price and the delivery price, St-K. Where St is the price at the time contract was initiated, and k is the price the parties have agreed to expire the contract at.
  • The payoff for a futures contract is calculated as the difference between the closing price of yesterday and the closing price of today. Based on the difference, it is determined who has gained, the buyer or the seller. Suppose the prices have decreased, the seller gains, whereas if the prices increased, the buyer gains. This is known as the mark to market payment model where the gains and losses are calculated on a daily basis, and the parties are notified of their obligation accordingly.
  • The payoff schedule for options is a little more complicated.
  • The payoff for swap contracts is calculated by netting the cash flow for both the counterparties. An example of a simple vanilla swap will help solidify the concept.

Advantages of Derivatives

Disadvantages of Derivatives

Conclusion

The bottom line is although it gives exposure to high-value investment, in the real sense, it is very risky and requires a great level of expertise and juggling techniques to avoid and shift the risk. The number of risks it exposes you to is multiple. Therefore unless one can measure and sustain the risk involved, investing in a big position is not advisable. Conversely, a well-calibrated approach with calculated risk structure can take an investor a long way in the world of financial derivatives.

Recommended Articles

This has been a guide to what are Derivatives in Finance & its definition. Here we discuss the most common derivatives in finance along with its advantages and disadvantages. You can learn more about accounting from the following articles –

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