Derivative financial instrument (derivative)
What are derivatives?
Derivative financial instrument (derivative) - is a financial instrument whose value, pricing and terms are based on another financial instrument that is the underlying instrument. In fact, a derivative is an agreement between two parties on an obligation or right to transfer a specified asset at a specified time and price.
Most derivative financial instruments are not securities according to the Federal Law "On the Securities Market", the exception being the issuer's option. However, so-called derivative securities, such as options, forwards, futures, swaps, etc., are common.
Why do we need derivative financial instruments?
The main purpose of using derivatives is to make speculative profits and risk hedgingboth temporarily and materially.
Derivatives are very important for risk management because they allow us to separate and limit risks. They are used to transfer elements of risk and thus they can serve as a certain form of insurance. The possibility of risk transfer entails for the parties to a contract the need to identify all the risks involved before the contract is signed.
To purchase a derivative financial instrument requires a small initial investment, unlike its underlying instrument, so often the number of such securities available in the market is not the same as the actual number of the underlying.
Types of derivatives
The classification of derivative financial instruments is based on two main features.
By type of underlying asset:
- Real goods: gold, oil, wheat, etc.
- Securities: stocks, bonds, bills of exchange and more.
- Currency.
- Indexes.
- Statistical data such as key rates, inflation rates, etc.
By the type of pending transaction:
- Forward contract
A forward contract is a transaction in which participants agree to deliver an asset of a certain quality and quantity on a specified date. The underlying asset in forward contracts is real goods, the rate of which is agreed in advance.
- Futures contract
A futures contract is an agreement under which a transaction must take place at a specific point in time at the market price on the date of execution of the contract. That is, if in the case of a forward contract the value is fixed, in the case of a futures contract it can change depending on market conditions. The obligatory condition of futures contracts is only that the goods will be sold/bought at a particular point in time.
- Option contract
An option is the right, but not the obligation, to purchase or sell an asset at a fixed price until a specific date. That is, if the holder of a company's shares declares his desire to sell them at a certain price, the person interested in buying can conclude an option contract with the seller. Under its terms, the potential buyer gives the seller a certain amount of money, and the latter agrees to sell the shares to the buyer at a fixed price.
However, such obligations of the seller remain valid only until the expiration of the period specified in the contract. If the buyer fails to complete the transaction by the specified date, the premium paid by him goes to the seller, who has the right to sell the shares to whomever he wants.
- Swap
Swap is a double financial operation, which involves the simultaneous purchase and sale of the underlying asset on different terms. In its essence, a swap is a speculative instrument and the only purpose of such actions is to profit from the difference in the price of contracts.
More about derivatives
- Weather derivatives - how to make money on degrees?
- Oil and gas futures: a profitable tool for trading
- Hedging and speculation with currency futures on the market