Sunday, July 21, 2013

What are Derivatives and types of Derivatives?

Derivatives are financial instruments whose value is derived from the value of their underlying assets. The underlying assets can be index, stocks, interest rate, commodity or any other asset.

What are Derivatives and types of derivativesDerivatives is a contract between two parties and it enable parties to trade specific financial risks such as interest rate risk, equity risk, currency and credit risk etc. to other parties who are more willing and better suited to take and manage these risks. Using derivatives helps to break risk into pieces that can be managed independently.

Importance of Derivatives
Derivatives are mostly used as risk management tool, using which parties transfer risk associated with the underlying asset to those who are willing to take that risk. There are several risks involved in financial transactions. Financial Derivatives can be used to minimize these risk form traditional instruments and transfer these risks to other entities that are willing to bear these risks and manage them. The kind of hedging that can be obtained by using derivatives is cheaper and more advantageous than using traditional cash instruments. It is because, when derivatives are used for hedging, actual delivery of the underlying asset is not at all required for settlement purposes.

The fundamental risks involved in derivatives are
  • Credit Risk: Credit risk arises when counterparty fails to perform its obligation as per the contract. It is also known as ‘default risk’ or ‘counterparty risk’.
  • Liquidity Risk: Liquidity risk arises due to the inability of the firm to perform the transaction at current market prices or due to uncertain cash crunch.
  • Market Risk: Market risk arises due to the losses in positions arising from adverse movements in market prices of the underlying instrument.

Participants of Derivative Markets
  • Hedgers: Hedgers enter a derivative contract to protect against adverse changes in the value of their assets. Specifically, they enter a derivative transaction such that a fall in the value of their assets will be compensated by an increase in the value of the derivative contract.
  • Speculators: Speculators attempts to profit from anticipating changes in market prices or rates or credit events by entering a derivative contract.
  • Arbitrageurs: Arbitrageurs operate simultaneously in two different markets to profit from price difference between two different markets.

Different types of Derivatives
  • Forwards: It is contract between two parties to buy or sell an asset at a specific price on a specific future date. It is not standardized and not traded on stock exchanges. If the future price of an asset increases, the buyer has a gain and the seller a loss.

  • Futures: A Future contract is a forward contract that is standardized and traded on exchange. The main differences with forwards are that futures are traded in active secondary market, regulated, backed by the clearing house and require a daily settlement of gains and losses.

  • Swap: Swap is an agreement between two parties to exchanges a series of cash flows of one financial instrument for those of another financial instrument for a stated period of time.

  • Options: Option is a contract that offers the buyer the right but not the obligation to buy or sell an asset at an agreed price during a specific period of time. There are two types of options:

Call option is an option that gives the buyer the right to buy a specified amount of assets at a particular price on or before a certain future date.

Put option is an option that gives the buyer the right to sell a specified amount of assets at a particular price on or before a certain future date.