Financial Derivatives
Financial derivatives are contracts or agreements giving the right, but not the obligation, to take some course of action at some time in the future. This can involve buying or selling a particular product, fixing a certain price, or creating a link between two parties. Derivatives are used extensively in the world of finance, from helping to reduce risk to claiming huge profits from cleverly placed investments.
By their very name, derivatives are based on something else – a fundamental asset or other derivative – to gain a value or derive the outcome of the contract. They take various forms, from basic derivatives such as commodities futures and options to more complex derivatives such as swaps and credit default swaps.
It is possible to obtain exposure to derivatives through financial exchanges, such as the London International Financial Futures and Options Exchange (LIFFE), or through over-the-counter markets. Financial derivatives open up new possibilities when it comes to managing risk and making more informed investments.
Commodity Futures
Commodity futures are a type of derivative contract that allows buyers and sellers of a commodity to agree on the price at which they will trade the commodity at a later date. This means that it is possible to speculate on the future price movements of commodities, as well as to implement commodity hedging strategies.
Futures prices are generally determined by the supply and demand for the commodity in question, although a range of other factors can play a role. For instance, economic and political events can have a significant role as well as the weather.
The vast majority of commodity futures contracts are traded on exchanges, with the most significant exchanges being located in New York, London, and Tokyo. These exchanges provide a regulated environment for participants to trade in and are subject to the rules of the particular jurisdiction.
Options
Options are derivatives in which the buyer has the right, but not the obligation, to buy or sell an asset at a predetermined price by a predetermined date. Options are versatile instruments used by traders and investors alike as they can offer flexibility, leverage, and the potential to lock in profits.
Options come in two types: calls and puts. Buyers of calls have the right to buy an underlying asset, whereas buyers of puts have the right to sell an asset. The price the buyer has to pay the seller of the option is known as the premium.
Options are particularly useful in hedging strategy and can be used by investors to limit their risk while still allowing them to have exposure to the markets. Options can also be used as part of a larger integrated hedging strategy also including other asset classes such as stocks and bonds.
Swaps
A swap is an agreement between two parties to exchange cash flows over a period of time or when certain events occur. Swaps are used for various purposes, including to transfer interest rate exposure, to reduce costs through changing the funding source, and to take advantage of various tax advantages.
There are various types of swaps, such as interest rate swaps, currency swaps, commodity swaps, and credit default swaps. Each swap has specific elements unique to that type of swap, such as the underlying assets, maturities, and currency of the cash flows.
Conclusion
Financial derivatives are contracts that allow two parties to take a course of action in the future, often with the purpose of reducing risk. Derivatives are typically based on some underlying asset, such as a commodity or currency, and are traded either on exchanges or in over-the-counter markets. They come in various forms, from commodities futures to options and swaps, and have a variety of uses from reducing risk to making more informed investments.
