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Advanced Explained: Derivatives and their types
Source: | Author:finance-102 | Date2022-12-29 | 153 Views | Share:
Derivatives are financial instruments that derive their value from an underlying asset. They are used to speculate on the future price movements of the underlying asset or to hedge against potential price fluctuations.

Derivatives are financial instruments that derive their value from an underlying asset. They are used to speculate on the future price movements of the underlying asset or to hedge against potential price fluctuations.


There are various types of derivatives, including forward, futures, options, and swaps.


Forward Contracts


Forward contracts are a type of derivative that allows two parties to enter into an agreement to exchange a certain amount of one currency for another currency at a predetermined exchange rate on a specific future date. As you mentioned, the exchange rate is fixed at the time the contract is entered into, and it remains fixed until the contract is settled on the agreed-upon future date.

One of the main advantages of forward contracts is that they allow traders to lock in a specific exchange rate for a future transaction, which can be helpful in managing currency risk. For example, if a company knows that it will need to make a payment in a foreign currency in six months' time, it can enter into a forward contract to buy the necessary currency at the current exchange rate, rather than having to wait until the payment is due and potentially face a higher exchange rate.

Forward contracts are not traded on an exchange and are instead typically negotiated directly between two parties. They can be customized to meet the specific needs of the parties involved and can have varying maturities, ranging from a few days to several years.

However, it's important to note that forward contracts involve counterparty risk, as one party is relying on the other party to fulfill their obligation under the contract. This means that if the other party defaults on their obligation, the first party may not receive the currency they were expecting. To mitigate this risk, traders may choose to use a clearing house, which acts as an intermediary between the two parties and ensures that the contract is settled according to the terms of the agreement.


Futures Contracts


Futures are financial contracts that obligate the buyer to purchase an asset, and the seller to sell an asset, at a predetermined price on a specific future date. They are traded on exchanges, and the price of a futures contract is based on the underlying asset, which can be anything from commodities (such as oil, wheat, or gold) to financial instruments (such as government bonds or currencies).

Futures contracts are standardized and typically have a set expiration date and a fixed quantity of the underlying asset. This means that all buyers and sellers of the same type of futures contract are essentially participating in the same trade, regardless of their individual motivations for entering into the contract.

Traders use futures for a variety of reasons, including to hedge against price fluctuations, to speculate on the direction of prices, and to take advantage of arbitrage opportunities. For example, a trader who is concerned about the potential for rising oil prices may enter into a futures contract to buy oil at a fixed price in the future as a way to protect against potential price increases. On the other hand, a trader who believes that the price of oil will decrease may sell a futures contract as a way to profit from the potential price drop.

It's important to note that futures trading carries the risk of loss, as the value of the contract can fluctuate based on market conditions. As such, it's important for traders to carefully consider their risk tolerance and financial goals before entering any futures contracts.


Options Contracts:


Options are a type of financial derivative, which means that their value is derived from the value of an underlying asset. Call options give the holder the right to buy the underlying asset at a predetermined price, known as the strike price, on or before a specific date in the future, known as the expiration date. Put options give the holder the right to sell the underlying asset at the strike price on or before the expiration date.

The person or entity that sells the option is known as the option writer. The option writer is obligated to fulfill the terms of the option if the holder chooses to exercise their right.

Options can be used for a variety of purposes, such as hedging against potential price movements in the underlying asset, speculating on the direction of price movements, or generating income through the sale of options. They are traded on exchanges or over-the-counter, and the price of an option, known as the option premium, is determined by a number of factors, including the price of the underlying asset, the strike price, the expiration date, and the volatility of the underlying asset.


Swaps Contracts:


A swap is a financial derivative contract in which two parties agree to exchange cash flows based on the performance of an underlying asset or set of assets. There are many different types of swaps, including interest rate swaps, currency swaps, commodity swaps, and credit default swaps.

In an interest rate swap, two parties agree to exchange periodic interest payments based on a fixed or floating interest rate. A currency swap involves the exchange of cash flows in one currency for cash flows in another currency. A commodity swap is an agreement to exchange cash flows based on the price of a particular commodity, such as oil or gold. A credit default swap is a type of insurance contract in which one party agrees to compensate the other party in the event of a default on a debt obligation.

Swaps are often used by companies and other organizations to hedge against potential changes in interest rates, exchange rates, or commodity prices, or to manage their overall financial risk. They can also be used for speculative purposes, such as betting on the direction of interest rates or commodity prices. Swaps are typically traded over the counter, rather than on exchanges.

In the forex market, derivatives are often used to speculate on the future movements of currency pairs. For example, a trader may enter into a futures contract to buy a certain amount of euros with U.S. dollars at a fixed exchange rate in three months' time. If the exchange rate between the euro and the U.S. dollar increases between the time the contract is entered into and the time it expires, the trader will profit from the difference between the agreed-upon exchange rate and the actual market exchange rate. If the exchange rate decreases, the trader will incur a loss.


Overall, derivatives can be complex financial instruments and are not suitable for all investors. It is important for traders to fully understand the risks and potential rewards of using derivatives before entering into any contracts.