Financial derivatives are essentially a financial contract between two people or two entities that depends on something that occurs in the future such as the performance of an asset, such as a stock, a bond, commodity, or a currency Hence the term ‘derivative' , i.e. denoting that their value ‘derives' from underlying assets like stocks, bonds and commodities.). These financial derivatives can range from something as simple as an unregulated private agreement to something that is hedged in by rules and restrictions as well as control.
¶ … financial derivatives? What are they used for? Types of derivatives. Types of derivatives markets (where are they negotiated).
What are financial derivatives?
Financial derivatives are essentially a financial contract between two people or two entities that depends on the fulfillment of an economic asset in the future, such as a stock, a bond, commodity, or a currency. The two parties make agreements between each other to ensure that all aspects of it will be covered and work in a specific way by a certain date. Financial derivatives, by the way, are called so since the term 'derivative' denotes that their value 'derives' from underlying assets like stocks, bonds and commodities. These financial derivatives can range from something as simple as a private agreement to something that is controlled by rules and restrictions.
Different types of derivatives
There are various derivatives that meet different needs.
Some of these derivatives are the following:
1. A swap:
This is the most common form of derivative. Two parties swap two of their assets that come from different investments in order to balance their respective portfolio and reduce risk. One party, for instance, might want to receive a higher interest from a floating interest rate whilst the other prefers the stability of a fixed interest rate. Each swaps with the other in what is called a "plain vanilla swap." In this way, each gains form the other what the other one wants as way of replacing one asset for another.
This is a simple swap. More complex swaps can involve 'swapping' several different assets in order to protect oneself against risk from various quarters (Milton, A.)
2. Futures
These are financial derivatives that are betting on future events such as investors betting that the stock market as measured by the Standard & Poor's 500-stock index will fall or rise.
Futures are traded on a formal stock exchange and their categories include stock index futures, interest rate futures, and currency futures.
A sub-category of this kind is a 'forward' that is traded outside of a regular exchange. It is an over the counter agreement and has standardized market features (Citeman, online).
3. Option
This is the right to buy or sell something at a specified price on a certain date. One such example of this is a basic agricultural futures contract where a farmer agrees to sell some grain to a broker next winter at a certain price. The price is set at that amount so if the price goes up the farmer loses on potential profit. However, if the price decreases in the meantime, the farmer is protected from loss but the contractor loses.
Major types of options include currency options, stock index options, stock options, bond options, futures options, and swaps.
There are two types of options:
a. Calls - the buyer can buy the asset on or before a specified time at an agreed-upon price and quantity.
b. Puts -- the possessor of the asset can sell the asset on or before a specified time at a particular price and quantity.
4. Warrants
These are long-term assets that last for three to seven years until they expire (in contrast to stocks that only have a nine-month guarantee). Warrants are derivatives used by companies as a means of procuring finance without incurring interest on.
The warrant is like a security that has a specific price that can be released at a specific date and in a certain manner. When issuing a warrant, the firm has to create a new share, which by doing so implies that the firm renounces ownership to the underlying asset. Warrants are often attached to bonds to make bonds more attractive to buyers, but actually warrants can be separated from entities (such as bonds) and sold in their own right.
These derivatives are also available on stock indices and currencies (Milton, A.)
4. "Credit-default swaps."
This derivative is problematic. The "credit-default swap" can become complicated since it involves the seller of the swap, the buyer of the swap and the underlying asset (such as a bond or loan). Given its complex nature, it has incurred historical problems.
The way it works is like this: The seller of the swap receives a fixed price from the buyer, and, in return, he agrees to cover losses that may arise by clients reneging on the underlying bonds or loans.
Many banks In Europe used these swaps to reduce the amount of cash that had have to keep in regards to loans. Investors also used this type of swap as bets on companies that may be unlikely to pay their loans. Each hoped to profit from this. It served as a betting game.
The "credit-default swap," however, was the derivative that was most responsible for the financial meltdown in that it became complex, corrupt, and unpredictable. Swaps and other derivatives were sold and resold in ways that concealed the amount of debt that certain financial institutions were assuming and in the early stages of the recession, the resulting fiasco and scandals of the mortgage business resulted in bankruptcy for many businesses that relied on these swaps.
Risk became so great that, in 2008, the Bank for International Settlements in Switzerland calculated that there was approximately $680 trillion-worth value of derivatives across the globe -- an increase from $106 trillion in 2002. The derivatives had the reverse effect. Financial derivatives are intended to prevent doubt and uncertainty. These credit-default swaps instead, generated insecurity and risk leading to Buffett's statement that derivatives, in the wrong hand, can be harmful (NY Times, 2012).
Types of derivative markets
A derivative market is a market that is based on another market. An example of this would be a market that is based on individual stock markets, or a market that is based on stock indices, or a market that is based on currency markets.
Derivative markets are traded in different ways: some are traded in the usual manner and others differently.
The most common forms of derivative markets are the following:
Futures Markets
Options Markets
Warrants Markets
Contract For Difference (CFD) Markets
Spread Betting
Futures markets and contract for difference markets are traded in the same ways as their underlying entity, whilst options markets and warrants markets are traded differently. Spread betting, on the other hand, uses a gambling rather than a trading approach and, therefore, can be traded in various forms.
Conclusion on Financial Derivatives
Financial derivatives have been used for more than three decades around the globe by individuals and institutions. In the years leading up to the financial meltdown, derivatives were often traded directly by banks to individual parties; the banks made millions whilst absorbing the risks. As result of controversy and reform, clearinghouses currently conduct the job whilst the banks conduct the transaction. This has transformed the business from a high-rewards / high risk enterprise to a more regulated, public business that is focused on quantity leaving the banks to strive for attracting clients.
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