What is Derivative?

A derivative is a contract between two or more parties based on an underlying financial asset (such as a security) or a group of assets (such as an index) whose value is agreed upon. Common underlying instruments include bonds, commodities, currencies, interest rates, market indices, and stocks.

 

 

Derivative Types

1-) Futures

These are financial contracts that oblige contract buyers to purchase an asset at a pre-agreed price in a specified future. Both forwards and futures are essentially the same in essence.

 

However, futures are more flexible contracts because the parties can customize the underlying commodity as well as the quantity of the commodity and the date of the transaction. On the other hand, futures are standardized contracts traded on exchanges.

 

2-)Options

Options provide the buyer of contracts the right, not the obligation, to buy or sell the underlying asset at a predetermined price. The buyer can exercise the option on the expiry date (European options) or any date before the expiry date (American options), depending on the option type.

 

3-) Swaps

Swaps are derivative contracts that allow the exchange of cash flows between two parties. Swaps often involve replacing a fixed cash flow with a variable cash flow. The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps.

 

Advantages of Derivatives

 

Unsurprisingly, derivatives have had a significant impact on modern finance as they provide numerous advantages to financial markets:

 

1. Exposure to hedging risk

Because the value of derivatives is linked to the value of the underlying asset, contracts are primarily used for hedging. For example, an investor may purchase a derivative contract that moves inversely to the value of an asset he owns. In this way, profits on the derivative contract can offset losses on the underlying asset.

 

2. Determining the price of the underlying asset

Derivatives are often used to determine the price of the underlying asset. For example, spot prices of futures can serve as an approximation to the price of a commodity.

 

3. Market efficiency

Derivative products are thought to increase the efficiency of financial markets. The return on assets can be multiplied by using derivative contracts. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

 

4. Access to unavailable assets or markets

Derivatives can help organizations access assets or markets that would otherwise be unavailable. By using interest rate swaps, a company can earn a more favorable interest rate than interest rates from direct borrowing.

 

Disadvantages of Derivatives

Despite the benefits that derivative instruments provide to financial markets, financial instruments also bring some important drawbacks. These disadvantages had disastrous consequences during the 2007-2008 Global Financial Crisis. The rapid devaluation of mortgage-backed securities and credit default swaps led to the collapse of financial institutions and securities around the world.

 

1. High risk

The high volatility of derivatives exposes them to potentially large losses. The sophisticated design of contracts makes valuation extremely complex or even impossible. Therefore, they carry a high inherent risk.

 

2. Speculative features

Derivatives are widely considered a tool of speculation. Due to the extremely risky nature and unpredictable behavior of derivatives, unreasonable speculation can result in huge losses.

 

3. Counterparty risk

While derivatives traded on exchanges often go through an extensive due diligence process, some over-the-counter contracts do not include a benchmark for due diligence. Therefore, there is a possibility of default by the counterparty.

 

Derivatives and Hedging

By entering a futures contract, Gail is protected from price changes in the market as she locks in a price of $30 per bird. When mad cow is frightened, it may lose if the price soars to $50 per bird but will be protected if the price drops to $10 at the news of the bird flu outbreak. By hedging risk with a futures contract, Gail can focus on her business and limit her worry about price fluctuations.

 

It is important to remember that when companies hedge, they do not speculate on the price of a commodity. Instead, hedging is simply a way for each party to manage risk. Each party's own profit or margin is included in its price, and hedging helps prevent these profits from being eliminated by market movements in the price of the commodity. Regardless of whether the price of the commodity at maturity was higher or lower than the price of the futures contract, both parties hedged their profits from the transaction by contracting with each other.

 

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