If you are active in the financial world, you would know that there are many different investing products to choose from – so many that it becomes hard to know which products can take your portfolio to new highs and which ones will become your biggest regrets. Among these many products are derivatives.
Derivatives have been coined to be the cause of the 2008 financial crisis. Though it earned a reputation for being risky, it can also be a portfolio superstar for experienced investors who know how to manage derivatives well and how to look for good derivative investments.
Derivatives involve a lot of financial instruments. They have underlying financial instruments and they depend on a specific financial market’s performance. Whatever happens to its underlying asset affects the derivative itself.
Investing in derivatives can lessen risks or create risks – depending on how an investor crafts her strategy. Derivatives can be risky if you invest in non-regulated instruments which do not require margin collaterals. However, they can also be good investments if they allow you to hedge against losing positions, leverage winning positions, and save on costs through proper speculation.
Ultimately, derivatives being good investments or bad investments depend on you and what you know. So it’s good that you’re here!
What are the types of derivatives?
The derivatives sector provides a broad spectrum of choices for investors. However, the financial engineering in these derivatives can be categorized into three types.
Options are contracts between two parties – one buyer and one seller. With the contract, they set a price to be paid at a particular date. If an investor purchases a call option, he gets the right to buy an asset. If an investor purchases a put option, he gets the right to sell an asset.
The beauty of options is seen in its versatility. It can be manipulated in any way traders and investors want to. Traders may benefit from options by speculating. Hedgers can benefit from options by reducing the risk of an asset that they are holding. However options are used, it poses customisation for a trader or an investor.
There are many kinds of options for investors to choose from. Here is a list of options that you can also look at:
- Call option – an option that gives the holder the right but not the obligation to buy an asset
- Put option – an option that gives the holder the right but not the obligation to sell an asset
There are also options that depend on the kind of its underlying assets:
- Equity option
- Bond option
- Future option
- Index option
- Commodity option
- Currency option
Some options only differ in style:
- American option – an option that may only be executed on or before its expiration date
- European option – an option that may only be carried out on expiry
- Bermudan option – an option that may only be used on specific dates before the expiration
- Asian option – an option which yields the average of the underlying price throughout a set period of time
- Barrier option – an option with specific rules that its underlying assets must pass before it can be executed
- Binary option – an option that pays the lump sum of its underlying assets if it meets the set conditions before its expiry date
Forwards and Futures Contracts
Forwards and Futures Contracts work like options where in one side buys and asset and one side sells it at a specified price and date. The difference is seen in the underlying security. These are usually used to hedge risks and speculate future prices.
There are only minor differences between Forwards and Futures. On one hand, futures are regulated and standardized. On the other hand, forwards allow private negotiations. Futures are done in exchanges, and forwards are done over-the-counter.
Here is an example of how a futures contract may work.
Imagine that you’re running a business in gold. The current spot price for gold, for example, is US $375 per ounce on February. To keep the business running, you decide to enter a futures contract with your supplier. The contract stipulates that on June, you will buy gold for $375 per ounce. In essence, you are locking this price against your supplier.
June finally arrives. Only two things may happen:
- The price of gold is higher than $375 per ounce and you are able to cut costs and save money.
- The price of gold is lower than $375 per ounce, and your supplier is able to profit from the contract while you lost money.
By entering a futures or forwards contract, businesses and investors can lock in prices at specified dates. It is a zero-sum game and extreme fundamental analysis must be used to increase your rewards against risks.
Swaps give the investors to trade the benefits of their assets with each other. For example, one investor may have fixed-rate bonds but is more interested in varying-rate securities. This investor may enter a swap contract with another party which may be more interested in fixed-rate bonds.
There are five generic kinds of swaps: interest rate swaps, currency swaps, credit swaps, commodity swaps, and equity swaps.
Interest rate swaps – This allows two parties to exchange interest rate cash flows. The exchanges are based on a specified notional amount. With this, companies who like fixed rates can borrow from companies who like floating rates and vice versa. This instrument makes it cheaper for companies to borrow money.
Currency swaps – exchanging fixed rate interest payments on loan of a currency to get the fixed rate interest payments on loan of another currency.
Commodity swaps – this is usually done for crude oil. Through commodity swaps, floating prices can be exchanged with fixed prices over a specific period.
Subordinated risk swaps – these are contracts which make the buyer pay a seller to carry some of the risks involved in an investment.
Swaps may be complicated and deserve separate articles. What you have to remember about swaps is this: They are useful when one side wants to get payment with floating interest rates and another wants to receive payment in fixed interest rate. Both sides have their own requirements, so exchanging the rate’s cashflow will be advantageous for both sides.
As you can see, there are many kinds of derivatives and each kind depends on what investors and traders need. Though derivatives may be complex in nature – as seen in the number of types – they offer a customisable solution for anyone who wants to use hedging, leveraging, and speculation as part of her strategy.
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