What are derivatives in finance?
Derivative contracts have existed since time immemorial, where they were used to maintain equilibrium in the exchange of goods or services on a global scale, however, today they are more present than ever because thanks to them, they have been left to a side differences between currencies and accounting systems that prevented transactions between users.
So, what is a financial derivative?
Financial derivatives, as mentioned above, are contracts that base their value on an underlying asset. In them, the seller of the contract does not necessarily have to own the asset, but can give the necessary money to the buyer for it to acquire it or give the buyer another derivative contract.
These financial derivatives are used to hedge investments and to speculate. Thus, if a trader wishes to speculate on a derivative, they can make profit if the price of their purchase is lower than the price of the underlying asset. For example: if you want to buy a futures contract (which we will talk about later) for any asset that has a price of $1,000, and the price of it at the end of the contract increased to $1,100, you will be earning $100. In addition, you could also benefit from the fall in the sale price of the asset you have selected.
They can also be used as a hedge, or to minimize the risks of a short term trade where you could be affected by fluctuations in the price of the asset.
Now, there is no single type of financial derivative, there are many. However, the three most used are: Options, Futures and Swaps.
Derivatives are not a new event for financial markets. According to some sources (mostly rumors), they appeared in the 25-21 centuries B.C. Merchants from Babylon needed to equip their caravans, so they started to make agreements with creditors. These agreements allowed them to get loans. Still, the repayment was influenced by how successful the delivery was. As a result, risks were distributed between parties. At the same time, the interest was much higher than the ordinary loan to cover losses in case the cargo is lost.
The next example of modern derivatives was found in 12-century Europe. The economic upturn caused trade development, and the trade law was created roughly at that time. The document called “lettre de faire” served as a forward contract for the goods delivery. The delivery was done at a certain time.
At the beginning of the 17th century, options for tulip bulbs were traded in Amsterdam. By the 1630s, the first forward contracts appeared on the Royal Exchange in England.
Later on, derivatives were used in Japan. The history dates back to the 1650s when Japanese landlords received rent in the form of the rice harvest. However, their rent depended on weather conditions. Landlords started to use warehouses to keep rice and used rice coupons. Owners of coupons acquired specific amounts of rice at a certain date at a predetermined cost in the future. Landlords got a stable income as a rent payment.
In the 1930-s, the modern put and call options became a usual thing on the London Stock Exchange.
By the 1960-s, options trading for commodities and stocks became standard practice on American stock exchanges. The first forward contract was made at the Chicago Board of Trade on March 13, 1851. And in 1865, grain trading was formalized by the introduction of futures contracts. These contracts were standardized by determining the specific quality and quantity of goods and the time and place of delivery.
In 1972, the International Currency Market department was created at the Chicago Mercantile Exchange. It became the first specialized exchange platform for trading currency futures contracts. Before, only commodities were used for futures trading.
Later in 1973, the Chicago Board Options Exchange was established. By the late 1970s, derivatives trading became common practice on the world’s stock exchanges.
The derivatives market is very large, it is said that it has around $ 1.2 million due to the large number of derivatives available for assets such as: currencies, stocks , bonds, or commodities. Even in 2016, a figure was announced that pointed to the 25 billion contracts of derivatives traded, where Asia led the way with 36% of the volume, North America with 34%, and 20% for Europe.
Today the derivative market is divided into two.
OTC: Over The Counter
Also known as non-exchange derivatives, these are contracts that are made directly and privately, that is, they are not listed on any stock exchange. They are usually used by investment banks.
They are quoted on the stock exchanges and are used mostly by small investors. They are public and the terms of the contract are predetermined.
Types of Financial Derivatives
Financial derivatives have marked important milestones throughout the global economy. Among the most popular are:
- Swaps and CDS
The CDO's (Collateralized Debt Obligation) are financial instruments that are considered the main cause of the economic crisis that occurred in 2008 and which based their value on the repayment of the loans offered.
The swaps offer investors the possibility of exchanging assets or debts for another of similar value, managing to reduce the risks for the parties involved. The swaps resulted in the CDS (Credit Defaul Swap), which was sold as insurance against the default of the municipal bonds and which contributed to the 2008 financial crisis.
Forwards are another type of OTC financial derivative and are used to buy or sell an asset at a previously agreed upon value on a specific date in the future.
In addition, there are financial derivatives that are used to trade in the network in a decentralized manner, that is, without an intermediary. The three most popular are the following.
The CFDs contracts for difference) allow you to buy or sell a certain number of units of a particular asset, depending on of the decrease or rise in its value and thanks to the leverage. The gains (or losses) will depend on the fluctuation of the price of the asset. With CFDs you can open long positions, if you think the price will increase or short positions, if you think it will decrease.
For example, suppose that the price of an action is $100 and you decide to buy a thousand shares of it for a total of $100,000. If the price increases to $105, you will be earning $5000, since for each share you bought you will earn an additional $5, your total profit being $105,000.
They are used to exchange an underlying asset at a future date and at a predetermined price, which protects buyers from drastic changes in asset prices. They are used mostly to trade commodities.
For example, a cookie maker could buy sugar futures at a set price. In this way, if the price of sugar increases considerably, the manufacturer can afford to buy the necessary quantity a few months later.
Options are contracts that are made between two parties and allows the owner to buy (call) or sell (put) assets at a specific price and at a specific date or before. They are used most frequently in stock trading.
In the options, the buyer has the right to buy or sell the underlying asset. While the seller is obliged to buy or sell it at the agreed price, as long as the buyer has exercised their right.
For example: suppose that the shares of a telephone company are valued at $95 today, but next month the company is launching a new device that will most likely increase the value of the shares. So we acquire call options at $100 for three months, which in the market have a value of $5 for each one. In three months, as buyers we can exercise our right, so the seller must sell the shares at $100.
Advantages and Disadvantages of Derivative Trading
Operating with derivatives can mean big profit or big risks. That is why to do it responsibly we must first acquire the necessary knowledge.
Among its main benefits we find that financial derivatives protect investors against losses while, at the same time, benefit them through the gains of the asset.
Unlike direct investments in stocks, derivatives allow you to make a profit quickly. They can also cause losses. In addition, you can create your own strategies so that you can use them to your advantage.
However, as it is an open market, the values are constantly fluctuating, which entails numerous risks. One of them, you can lose all the value of your investment in a matter of minutes, if the price of it falls considerably.
On the other hand, most contracts have a predetermined duration, so if your investment does not prosper within the agreed time, your losses could be 100%.
Finally, the little knowledge we have about derivatives is a big risk. As its value depends on the value of an action, assigning an exact price becomes complicated, which draws the attention of fraudsters who take advantage of the situation and operate against professional investors and beginners.
CFDs vs. Futures and Options
Both CFDs and futures and options allow you to trade based on the variations that an asset presents. That is to say, when operating with derivatives you do not buy or sell the asset itself. In addition, both allow leverage, so you can make transactions with more money than you currently have. However, CFDs allow leverage to be made with smaller amounts and with totally different assets.
To decide which one to operate with, you must first know what you are looking for, since each of the derivatives has particular characteristics. For example, futures and options are ideal for opening long term positions, since their daily commissions are cheaper and their opening rates are higher than those of CFDs. Therefore, CFDs are better suited to small and short positions.
On the other hand, the CFD, having greater liquidity and not having an expiration date, allows the position to be closed at any time. While with the futures and options it is probable that there is not enough liquidity and the cost to undo the position is very high.
Is It Worth to Trade Futures or Options?
Previously, we talked about the differences between CFDs and futures and options. However, you must also take into account certain particularities between futures and options so that you can choose the one that best suits you.
When it comes to futures contracts, the buyer must obligatorily pay the agreed amount initially at the time the expiration date arrives, while, with options, the buyer can cancel the contract.
Therefore, operations with future contracts are much stricter and provide greater security. Options, on the other hand, are less rigid and will allow you to leave the operation if the circumstances warrant it.
Why Invest in Derivatives?
While it is true that these are volatile investments, derivatives can be an excellent option to get the most out of your portfolio.
Using financial derivatives, it is possible to speculate and take advantage of the variations presented by the prices of the underlying assets, but it is also possible to manage and reduce the risks that an investment brings with it.
In the case of speculation, it is possible to make a profit if the purchase price of an asset is lower than the price presented by the same asset at the end of the futures contract.
On the other hand, when we talk about the use of derivatives to manage risks, the owner of an action can protect his portfolio against a decrease in the value of his stock thanks to the use of a financial derivative. If the stock increases, you can earn more money, but if the stock falls you can earn or lose less money.
In turn, the increase in leverage is another excellent reason to operate with derivatives, since you can trade only having $10 and have a possibility to open a position worth $100 or $1,000.
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What Is A Derivative Example?
A convertible bond can be considered as an example of a derivative. The value of a convertible bond will depend on the value of the underlying stock, which makes it a derivative security.
What Are Derivatives and Its Types?
A derivative is a financial instrument. Its value is based on one or more underlying assets, for example, bonds, commodities, currencies. There are four types of derivatives, such as futures, swaps, options, and forwards.
Why Do Companies Use Derivatives?
Derivatives are a perfect way to hedge portfolios and reduce risks. Moreover, they are easily operated and have a low cost.
What Are Derivatives in Simple Words?
A derivative is a contract that allows or obligate parties to perform some actions concerning an underlying asset. Derivatives can be structured on a range of different assets, including futures, CFDs, commodities, etc.
What Are Derivatives Used For?
Derivatives are used to hedge investments. Another purpose is to speculate on future moves in the underlying instrument.