What are Financial Derivatives?

Financial derivatives are securities, a type of financial instrument which has an underlying asset or group of assets which decide the value of the derivative. This financial instrument is a contract between two parties. The price of the security of determined by movements in the underlying asset whether upward or downward.  The investors hedge their position with the help of financial derivatives.

The most commonly used derivatives are futures, options, forward, and swaps. And the most commonly used underlying assets are stocks, bonds, currencies, commodities, etc. These underlying assets are mostly purchased through brokerages.  Weather data such as the amount of rain or no sunny days can also be used for derivatives.

Financial Derivatives can be Traded in two ways

  • Over the counter (OTC) - In the derivatives market, a great portion of transactions are carried through OTC mode. These have greater counterparty risk than on exchange transactions. It is the risk under which there is a possibility that one of the two parties involved in the transaction might default, these transactions are generally unregulated.
  • On-exchange - These derivatives are more standardized and regulated such as futures and stock options. It reduces or eliminates the risk of over the counter. As the derivatives are more standardized in exchange transactions, it improves the liquidity of the derivatives and makes them more useful for hedging.

Forms of Financial Derivatives

It is a growing market that can be used for speculation and risk management. It has many forms which are:

  • Futures:  It is a contract between two parties, under which purchase and delivery of an asset will happen at a price agreed on a future date. These contracts are standardized and traded on the exchange.  Under this, both parties must fulfill their obligation.
  • Forwards:  These are the contracts that are somewhat similar to a future contract. These contracts are not traded on the exchange but traded only over the counter. Being OTC contracts, these carry a lot of counterparty risk. Under this, both the parties can customize the terms and conditions of derivative, and settlement process, and size of derivative.
  • Swaps:  These are the contracts that are used for exchanging one kind of cash flow with another. It can be used to exchange the risk of interest rate on variable loans.
  • Options: It is a contract between two parties, under which buy or sell of an asset will happen at a future date at a specified price. The basic difference between futures and options is that under option, the buyer is not obligated to complete or exercise the contract to buy or sell. It is an option to him whereas futures being an obligation on the buyer.

Advantages of Financial Derivatives

It is a common tool used by investors providing certain advantages which are:

  1. It provides a way to lock the prices and avoid deviations of the market.
  2. It helps in hedging against the movement in rates.
  3. It helps in mitigating risk at a limited cost.
  4. It is a less expensive tool to hedge your risks.
  5. It can be used to diversify the portfolio.

Disadvantages of Financial Derivatives

Along with certain benefits, there are certain disadvantages for the same:

  1. It is very difficult to derive the value of derivatives as they are based on the value of the underlying asset.
  2. Many of the derivatives are subject to counter-party risks.
  3. These are very complex to understand.
  4. The value of derivatives depends upon the cost of underlying assets and interest rates.
  5. They are sensitive to market risk and depend upon the sentiments of the market.

Participants in the Derivatives Market 

Different types of participants have a different objective to participate, on the basis on which it can be divided into few categories:

Hedgers - These are traders in the market. It is used to secure the investment portfolio against the market risk and movement in the market. It transfers the risk to others who are ready to take the risk.

Speculators - These are considered risk-takers of the derivatives market. They have an opposite point of view compared to hedgers. It helps them to earn huge profits.

Margin traders - It is the minimum amount that needs to be deposited with the broker to participate in the derivative market. It reflects gains or losses daily due to market movements.

Arbitrageurs - These are the investor who takes advantage of the inefficient market to earn the profit. They earn profit from the different derivative prices in different exchange markets because they purchase the derivative from one market at a lower price and sell it in another market at a higher price.

Derivatives exchange and regulations

Trading of derivatives is done on the National securities exchange. These derivatives are regulated by U.S Securities and exchange commission (SEC). Some derivatives are traded over the counter under which mutually decided agreements are carried between parties.

Two-party derivative

It is a commodity future contract to buy or sell a fixed amount of commodity at a present price, on any future date. These commodity futures are used to hedge investors against unfavorable movements in the price of the commodity. These are used by farmers to provide a degree of insurance.

Derivatives and Hedging

Hedging is a way to manage the risk not to speculate the price of any securities. The profit of each party is built in the price they quote, hedge helps to eliminate the profit due to fluctuations of the market.

Derivatives Swap

It is the use of derivatives in interest rate products. These are used to hedge against interest rate risk. Interest rate risk occurs when a change in interest rate leads to a change in the price of an underlying asset. For example- Variable rate loans, under which the rate of loan fluctuates based on the market rate of interest.

Context And Applications

Derivatives is an evolving field used by investors used to hedge the risk due to fluctuation in the market. It is useful in the following courses:

  • MBA
  • CFA
  • CFP
  • CPA

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