Derivative Instruments – All You Need to Know

Derivative instruments

The derivatives are instruments that do not have intrinsic value. On the contrary, the value of the derivatives is derived from one or more underlying. These underlying can be stocks, bonds, currencies, stock indices, commodities, or precious metals.

The basic theme of derivatives is to mitigate the risk by hedging. The science is to invest in derivatives whose price moves opposite to the assets being hedged. This will result in the protection of the assets/commodity partly or in full.

In addition to this, derivative instruments are also used by speculators. The speculator seems to be optimistic about the profitable movement of the underlying.

For instance, the speculators predict an increase of the price than present market value and enter in contract to purchase the asset/commodity in the future.

This helps them make a profit as prices would have increased, and they will be buying at today’s price (the day of the contract).

On the other hand, the second party to the contract must be expecting a decrease of the underlying’s price and hedging/speculating.

Similarly, the speculators might expect prices to decrease for an underlying asset. So, they enter into a contract to sell the asset/commodity at the price of today.

So, if their expectation is proved to be accurate, they profit by selling at the price of today (which is higher than the future price).

On the other hand, the second party must be speculating/hedging while expecting an increase in the prices. So, the parties’ expectations should be different from the same commodity to enter in the contract.

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The trading place for derivative

The derivatives trade over the trade and on the exchange as well. A greater portion of the derivatives is traded over the counter.

In the OTC, there is a greater risk of default from one of the parties that might be at loss due to the derivatives contract. Further, OTC derivatives are not regulated, which brings greater risk to the contract’s overall risk.

On the other hand, the derivatives also trade on the exchanges. These types of derivatives carry little risk of default as these are standard instruments and heavily regulated.

So, it decreases the risk of default. The derivatives exchange acts as an intermediary for all the related trade and charges to both sides of the parties to manage the facility for them.

Types of the derivatives

In today’s world, four common types of derivative instruments include Futures, Forwards, Options, Swaps, etc. We’ll discuss these types of derivative instruments.

Futures

These are the standardized contracts between two parties to purchase and deliver the asset in the future for the agreed-upon price. There is no exchange of consideration while entering in the future as it does not carry any intrinsic value.

However, if one has joined in the contract for the derivative it must fulfill the commitment to buy or sell the underlying asset.

Forwards

These are the customized contract between two parties to purchase and deliver the asset for an agreed-upon price. The forwards are similar to futures. However, the forwards are traded over the counter, and terms can be customized if both parties agree on the terms.

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However, forwards carry a greater risk of the party default as there is no regulation applicable to the contract.

Swaps

Swaps is the exchange of one type of cash flow with a different kind of cash flow. For instance, the business has issued variable rate interest bonds.

However, it’s now expecting that the interest rate will rise and the business has to incur additional financial charges.

On the other hand, another business has issued fixed-rate bonds and expecting the interest rate to fall. Hence, both of these businesses can exchange their cash flows to satisfy their current expectation.

Options

Options is a contract similar to futures and involve terms to sell/purchase the assets/commodity in the future at a pre-set price.

However, it’s an option, and buyer is not obliged to exercise their agreement to buy or sell. On the other hand, if the business has entered into a futures agreement, they have to exercise as per regulations.

Advantages of derivatives

Derivatives play an important role in the financial markets of the world. Following are some of the advantages associated with the derivatives.

  1. The derivatives help to mitigate the risk for the business, since the value of the derivative moves in a direction opposite to the underlying asset. Hence, if there is a reduction in the value of an underlying asset, an increase in the worth of the derivative offsets the loss.
  2. It helps businesses to get access to the unavailable markets. For instance, the company can get swap its variable rate of interest with the fixed rate of interest.
  3. Derivatives are considered to increase the efficiency of the financial markets. For instance, the derivatives help to sustain the worth of the underlying assets. Hence, the worth of the underlying asset and the associated derivatives tend to be in equilibrium, and this helps to bring market efficiency.
  4. Derivatives can be useful in the determination of underlying asset prices. For instance, the futures’ spot price can help determine the approximate price of the commodity.
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Disadvantages of derivatives

The derivatives can actually be the cause of the loss if not dealt with due care. Following limitations are associated with the derivatives.

  1. The derivatives are primarily affiliated with the speculation. These instruments are extremely risky. So, if the expectation of the speculator is not reasonable, it can lead to huge losses.
  2. Derivatives like forwards are traded over the counter and do not have any standard terms/applicable regulations. Hence, the risk of counter-party default increases.
  3. The derivative is a complex concept, and the valuation can be extremely challenging sometimes.

Dealing with derivatives requires a strong understanding of the financial market dynamics. Hence, due care needs to be taken to ensure smooth dealings. Further, the problem is that the inherent risk of the derivatives is higher that might lead to loss if there is any negligence.

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