Derivatives: Meaning, Types and Benefits of Derivatives

What are Derivatives

Derivatives are financial agreements whose value is derived from an underlying asset or group of assets. These are widely used for speculation and financial gain. They were also used by certain persons to shift risk.

These contracts have their own risks and can be used to trade a wide range of assets. Derivative prices are based on changes in the underlying asset. These financial instruments can be traded to reduce risk and are frequently used to get access to specific markets. Derivatives can be used to either accept risk with the intention of receiving a similar reward (speculation) or to mitigate risk (hedging). The risk-averse can transfer risk (and the associated profits) to the risk-takers using derivatives.

Types of Derivatives 

The following list of derivatives types includes:

1. Forwards: It is a specific contract between two parties to purchase or dispose of a good, service, or commodity at a specified price at a later time. Forwards are not standardised to be managed, and they are not traded on any central exchanges but rather over-the-counter. As a result, even if it cannot ensure profits, it is largely successful in hedging and lowering risk.

Over-the-counter Counterparty risk applies to forwards as well. A form of credit risk known as counterparty risk involves the possibility that the buyer or seller won't be able to keep their end of the bargain. The opposite party may not have any recourse to maintain their position if a buyer or seller declares bankruptcy and is unable to fulfil their obligations.

2. Options: Options are financial contracts that give the buyer or seller the choice but not the obligation to buy or sell securities or other financial assets. Options and futures are very similar. It is an arrangement or contract between two parties to purchase or dispose of any kind of security at a certain price in the future.

The parties can sell or buy the security at any moment because they are not legally obligated to uphold their half of the agreement. It is merely a choice made available to reduce risk in the event that the market becomes unstable.

3. Futures: The fundamental difference between futures and forwards, which are essentially similar financial contracts, is that features of futures can be traded on exchanges, leading to standardisation and regulation. The speculative use of commodities frequently involves them.

4. Swaps: Swaps are precisely what they sound like, as the name suggests. A sort of financial derivative called a swap is utilised to change one kind of cash flow into another. Swaps are secret agreements between individuals that are typically traded off exchange and not on exchanges.

The two most common types of swaps are currency swaps and interest rate swaps. A variable interest loan can be changed to a fixed interest loan or vice versa using an interest rate swap, for instance.

Examples of Derivatives

Futures contracts, options contracts, and credit default swaps are typical types of derivatives. Beyond this, a sizable number of derivative contracts exist that are made to satisfy the requirements of a wide range of counterparties. In fact, since many derivatives are traded over-the-counter (OTC), they are theoretically open to an endless number of variations.

For instance, one sort of derivative whose value is reliant on the market price of oil is an oil futures contract. Derivatives have grown in popularity over the past few decades; as of June 30, 2021, it was predicted that there was $610 trillion worth of outstanding derivatives.

Benefits of Derivatives

• Lower transaction costs: Trading in the derivatives markets has a low transaction cost when compared to other securities like stocks or bonds. Derivatives ensure lower transaction costs because their main purpose is risk management.

• Hedging Risks: Derivatives are the ideal tool for risk hedging, which is the process of lowering investment risk by creating a new one. With the intention of lowering market risk, derivatives are frequently employed as insurance policies to reduce risk.

Conclusion

The usage of derivatives can be a very effective instrument for reaching financial goals. A derivative is a common instrument for gaining money through speculation. Because of the market's volatility, speculating is exceedingly risky and can lead to large losses. A company can, for instance, buy or sell energy derivatives like crude oil futures in order to manage its commodity risk. To reduce its currency risk, the firm could potentially buy currency forward contracts.

Written by Melita Pinto