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Derivatives in Finance

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

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. The value of this underlying asset experiences movements due to market changes and other factors. The fundamental idea of investing in these assets is to speculate their future price and protect them from volatility.

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The major forms of dealing in derivatives are driven by exchange-traded derivatives and over-the-counter (OTC) derivatives. An investor would require a trading account to deal in these forms of investments. However, it is vital to understand that the risk of market volatility is prevalent and one must use proper hedging strategies to mitigate the risk.

Key Takeaways

  • Derivatives in finance are financial instruments that derive value from an underlying asset, index, or reference rate.
  • Derivatives play a crucial role in financial markets, allowing participants to manage risk, speculate on price movements, and gain exposure to various asset classes.
  • Common derivatives in finance include futures contracts, options contracts, swaps, and forward contracts.
  • Derivatives offer leverage, enabling investors to take more prominent positions with a smaller initial investment.

Derivatives in Finance Explained

Derivatives in finance are contract that derive their value from an underlying asset and investors make money from these contracts through the movement in price which is created due to the movement in its market value.

Types of derivatives include futures and options, swaps, and forwards. Speculators, hedgers, and investors use derivatives to take full advantage of the market volatility. An investor agrees to buy a particular asset at a specific price; the seller also enters into a similar agreement and when the two entries match, a transaction is registered.

Money is made out of the market movement of the underlying asset, which can be stocks, bonds, currencies, commodities, etc. It is vital to understand that these assets are not risk-free, there is always an inherent risk of market volatility.

It is natural that the underlying asset’s nature determines the volatility of the derivative. For instance, stocks are usually more volatile than commodity derivatives in finance. Therefore, depending on the investor’s risk appetite, they choose the asset and use strategies to earn premiums.

Investors, speculators, and hedgers use their knowledge and expertise to hedge the risk using various techniques. Most of these transactions are carried out through exchange-traded derivatives or over-the-counter deals.

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 a calculated risk structure can take an investor a long way in the world of financial derivatives.

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Types

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. The detailed discussion below will help us understand the intricacies of the concept.

# 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. However, the 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.

Uses

Let us understand the uses of commodity derivatives in finance and other types through the explanation below.

#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 riskCounterparty RiskCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract.read more 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 a 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 advantageComparative AdvantageIn order to determine comparative advantage, the opportunity cost of each item from each country needs to be calculated. Then, on a comparative table, these costs are plotted to get the comparative advantage.read more. 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

Now that we understand the different types and how these investments work, it is pivotal for us to understand the calculation mechanism used to experience premiums from these deals.

Advantages

Let us understand the advantages of commodity derivates in finance and other types through the points below.

Disadvantages

Despite the various advantages, there are a few factors from the other end of the spectrum that prove to be hassles for investors. Let us understand the disadvantages through the discussion below.

Frequently Asked Questions (FAQs)

How are derivatives used for risk management?

Derivatives are commonly used for risk management in finance. For example, companies can use products to hedge against adverse price movements in commodities or currencies, protecting their profitability. Investors can also hedge their investment portfolios against market volatility using derivatives.

What is the role of derivatives in speculation?

Derivatives provide opportunities for speculation, allowing investors to profit from anticipated price movements without directly owning the underlying asset. Traders can take positions in derivatives contracts based on their expectations of future market movements, aiming to capitalize on price fluctuations.

How do derivatives provide market liquidity?

Derivatives contribute to market liquidity by attracting participants looking for hedging or speculative opportunities. Market makers and other liquidity providers facilitate trading in derivatives, ensuring buyers and sellers can quickly enter and exit positions. The availability of results enhances overall market liquidity.

Are derivatives regulated in finance?

Yes, derivatives are subject to regulation in most financial markets. Regulatory frameworks promote transparency, mitigate risks, and protect market integrity. Restrictions include reporting requirements, capital adequacy standards, position limits, derivatives exchanges, and clearinghouse oversight.

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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