Financial derivatives are financial instruments that are used for managing risk. They are contracts between two parties that derive their value from an underlying asset or reference rate. The underlying asset can be anything from stocks, bonds, commodities, currencies, or indices. Derivatives are traded on exchanges and over-the-counter (OTC) markets.
Types of Financial Derivatives
There are several types of financial derivatives:
Forwards – A forward contract is a customized contract between two parties to buy or sell an asset at a specified price and date.
Futures – A futures contract is a standardized contract to buy or sell an asset at a specified price and date.
Options – An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a specified price and date.
Swaps – A swap is an agreement between two parties to exchange cash flows at periodic intervals.
Uses of Financial Derivatives
Financial derivatives are used for several purposes:
Hedging – Derivatives are used to hedge against price fluctuations in the underlying asset. For example, a farmer can use a futures contract to lock in a price for their crops.
Speculation – Derivatives can be used to make a speculative bet on the future price of the underlying asset. For example, an investor can buy a call option on a stock if they believe the stock price will rise.
Arbitrage – Derivatives can be used to take advantage of price discrepancies between markets. For example, an investor can buy a futures contract in one market and sell an equivalent futures contract in another market at a higher price to make a risk-free profit.
Risks of Financial Derivatives
While financial derivatives can be used for managing risk, they also come with their own set of risks:
Market risk – Derivatives are subject to market risk, which is the risk of loss due to adverse price movements in the underlying asset.
Liquidity risk – Some derivatives can be illiquid, meaning they cannot be easily bought or sold without affecting the price.
Counterparty risk – Derivatives are contracts between two parties, which means there is counterparty risk – the risk that the other party will default on the contract.
Financial derivatives are complex financial instruments that are used for managing risk. While they can be useful for hedging and speculation, they also come with their own set of risks. It’s important to understand the types of derivatives available and their uses before investing in them.