What Are Derivatives and How Do They Work

Derivatives are common in many disciplines and the word connotes different meanings across the various disciplines.

Even so, our main concern is its relevance as far as finance is concerned. In this context, it refers to a contract between two or more parties.

The value of this contract is based on an underlying asset, either a security or an index that has been duly agreed upon by the parties. Most of the underlying assets could include bonds, currencies, commodities, stocks, bonds, market indices, and interest rates.

Derivatives and Exchange Rates

Derivatives were generally used to balance exchange rates of goods traded in the international arena. Specifically, due to the fluctuating nature of different currencies, there was a great need for a system that would account for these differences.

Thus, the derivative emerged. In contemporary time, they are used in a multiplicity of ways. Another point to take note of is that due to the various securities available, there are also different types of derivatives in the market. This difference is seen in their functions and applications.

Examples of common derivatives include:

  • Futures contracts

These are the most common derivatives. A futures contract is an agreement between parties that is centered on selling an asset at a price mutually agreed. The most common use is to hedge against a certain risk for a given period.

  • Forward contracts

These are similar to futures contracts. The only difference is on how they are traded. While you can trade a futures contract on the main stock exchange, forward contracts are traded over the counter.

  • Credit derivative

This form of derivative is the most ideal when you want to lower your risk and at the same time increase the liquidity of assets.

This is because it is sold at a reduced price as compared to its true value. Well, doing this automatically means that the investor gets lower returns.

Even so, this is done speculatively so as to recover most of the investor’s capital. This recovered capital may be used to issue a new and more profitable loan.

  • Swaps

These are forms of derivatives in which the contracting parties agree to specific terms regarding trade loans. The contracting parties are keen on the nature of the loan – whether the interest rate is variable or fixed.

Someone who has a variable interest rate loan might find it hard to secure a trade loan since the lender would be hesitant.

This hesitance would be due to the uncertainty that variable interest rate loans have. It is also pegged in other factors such as the creditworthiness of the party or individual.

Thus, common practice is that the swap will be done with a party that has a fixed interest rate loan in order to remedy this.

Swaps can be carried out in a variety of ways that is, currency, interest rate, and commodities though there is an associated risk that comes with this.

A party may default in the payment of the other party’s loan thus making the party to inevitably pay the original loan.

  • Options

With options, the agreement is centered on giving a party the opportunity to buy or sell securities at a predetermined future date.

It is similar to a futures contract only that the party that will buy or sell is not obligated to do so. This is why it’s referred to as an option.

  • Spread Betting

With this, you are able to trade on price movements of a multitude of indices, currencies, and shares. If you buy them, you will profit from increasing prices. Again if you sell, you profit from fall of prices.

Common Use of Derivatives

The common use of derivatives today is for speculation. This speculation is carried for the sole purpose of benefiting from the profit that accrues from changes in the price of an asset.

Another area in which derivatives are commonly used is in hedging. Hedging enables one to transfer the risks of underlying assets between the contracting parties.

Another use of derivatives is for insurance purposes. They provide insurance to some certain degree.

This is because both the supplier and consumer in both aspects are locking in on a guaranteed price and supply respectively, though this limits the producer in that they will not benefit from the increased revenue when prices rise.

In conclusion, derivatives have to be used decisively. If you are contemplating using them, you should make a point of understanding them and using a cost-benefit approach in applying them.