Derivatives are bought and sold every day in huge amounts in the market. They make such a significant impact on the economy that it’s high time we make ourselves aware of what Financial Derivates are? How are they used? Why are there so many derivates in the market today?
Warren Buffet calls them ‘Financial Weapons of mass destruction’ in his 2002 shareholder letter. Do not be intimidated by Buffet’s words. He himself used them a lot.
What are financial derivatives?
So, what are financial derivatives? The word derivates come from the term derives.
Therefore, a financial derivative derives its value from something else.
Derivative is a financial contract between two parties. The contract is usually
regarding an exchange of goods, services, or currencies on some future
value of the financial derivative is based on an asset, also known as the
underlying asset or the underlined. The derivative’s value may fluctuate with
an increase or decrease in the value of the underlying asset.
underlying asset could be anything, company shares, a house, your car, etc. In
fact, pretty much anything of value can become an underlying asset, even
Why are derivatives used?
are two main uses of derivatives. They are:
take risks in business every day. To minimize this risk, they use
instance, an airline company needs oil for fuel in huge quantities. The market
price of oil barrels keeps fluctuating. An increase in the price of oil will
bring them loss. They cannot buy a year’s oil today as they’ll have to invest
thousands of dollars, not to mention the risk they will be putting themselves
in storing explosives.
answer to this is a financial derivative. They will sign a Financial Derivative
with an oil company to provide them with oil at a future date on the prices of
today. This way, they will hedge their exposure to fluctuations in the price of
oil barrels in the future.
derivative between the oil company and the airline company is a ‘Zero-Sum
Game.’ There will be a distinct winner and a distinct loser. If the price of
oil rises, the oil company will be at a loss, and if it falls, the airline
company will be at a loss.
derivative hedgers are usually looking to minimize their risk and protect
themselves from future loss, they are not looking for profit. Derivative
speculators are influenced by profit. They look for opportunities to make money
out of a contract.
do speculators make money? They earn profit by selling these contracts before
their maturity to another interested party. For instance, the price of the oil
increased, but the oil company is liable to sell oil to the airline company
because they signed a derivate. The airline company can sell this derivate to
another party who needs the oil. This way, it would get money from the third
party which buys the contract and gets oil at lower rates than available at the
market. Therefore, it is a win-win situation for both.
Types of Derivatives
four main types of derivatives are mentioned below.
type of contract is a customized deal settled among two parties. One is the
buyer, and the other is a seller. They agree on a fixed price of the commodity,
which will be traded at a future specific date, also called the maturity date.
contracts are initially used by companies that use derivatives for hedging.
type of contract is similar to the forward contract with a lit bit of
variation. This legal agreement works for the purchase or selling of assets at
a certain time in future. Futures are traded in the stock exchange, like
shares. The initial contract was made to make a profit and not use the
commodity, and the contract changes many ownerships before its maturity date.
is an agreement made between two parties for the facilitation of a transaction
at a pre decided price. This type of derivative do not make the buyer liable to
buy or sell the underlying asset at the maturity date. While the value of the
derivates is the same as the value of the underlying asset, in an options
contract, the owner of the derivative is not the owner of the asset. All
options contracts are settled in cash.
that are used for interest rate commodities are ‘Swap Contracts.’ In this type
of derivative, interest rates are swapped. For instance, two parties are having
a similar nature of the loan. One holds a variable interest rate while the
other holds a fixed interest rate. If, at some point, both feel they will benefit
from the other parties’ interest rate, they would swap.