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What Is a Derivative?

Sebencapital

Published
02/01/24
Beginner's Guide to Trading Penny Stocks

DEFINITION:

Derivatives are financial tools whose value is linked to another asset, like stocks, commodities, currencies, or indices. They get their worth from various underlying assets.

Key Takeaways

  • Derivatives can be utilized for speculation, like purchasing a contract for a commodity, anticipating its price to increase later on.
  • Derivatives can also help reduce risk, like when a company makes an agreement for a commodity at a fixed price to manage the risk of its fluctuating price.
  • Different types of derivatives consist of options contracts. These contracts provide the holder the choice, though not the requirement, to buy or sell the underlying security.
  • The 2007-2008 subprime mortgage crisis is an instance highlighting the risks associated with derivatives.

Definition and Example of a Derivative

There are various types of derivatives that help manage risk by fixing the price of the underlying asset. For instance, a business needing a particular resource might make a contract with a supplier to buy that resource at a set price in advance, securing the price even if the market value of the resource changes later.

This contract is the derivative, while the actual resource is the underlying asset. If the resource's market price increases more than expected during the contract period, the business saves money by buying it at the lower fixed price. But if the market price falls or doesn't rise as anticipated, the business loses money because it must purchase the resource at a higher price than the market's.

Companies often use derivatives to set a fixed price for raw materials necessary for their production. By doing this, they protect themselves from potential price hikes in raw materials that could affect their profits. While they might face a small loss, it guarantees stability in prices. Derivatives are commonly used for purchasing commodities like copper, aluminum, wheat, sugar, and oil.

How Derivatives Work

Derivatives serve two main purposes: speculation or risk hedging. They can play a stabilizing role in the economy, but they can also cause severe disruptions. One example of problematic derivatives is mortgage-backed securities (MBS), which contributed to the subprime mortgage crisis of 2007-2008.

Usually, trading derivatives involves more complex strategies such as speculating, hedging, options, swaps, futures contracts, and forward contracts. When used wisely, these methods can help traders manage risks effectively. However, if misused, derivatives can pose risks to both individual traders and large financial institutions.

Types of Derivatives

You can buy derivatives in two main ways: through a broker in standardized contracts known as "exchange-traded," or in nonstandard contracts called over-the-counter (OTC).

Futures Contracts

Futures contracts are mainly used in commodity markets. They're deals to buy commodities at fixed prices on specific future dates. These contracts have set prices, dates, and amounts and are traded on an exchange. They also get settled daily.

Forward Contracts

Forward contracts are similar to futures but are not standardized. They're traded over-the-counter and allow both parties to personalize the contract terms.

Similar to futures, they involve an agreement to buy or sell the asset at a specific date and price. However, unlike futures, these contracts settle at the end date, not on a daily basis.

Options

Options offer traders the choice to buy or sell an asset at an agreed price by a specific time.

Note

Options are mainly traded on exchanges like the Chicago Board Options Exchange or the International Securities Exchange as standardized agreements.

Options can carry risks for individual traders. Exchange-traded derivatives like these are backed by the Options Clearing Corporation (OCC), a registered clearinghouse with the Securities and Exchange Commission. When a buyer and seller make an options contract, the options exchange becomes the middleman. The OCC acts as the buyer to the seller and the seller to the buyer in these transactions.

Swaps

Businesses, banks, and financial groups often use agreements called "interest rate swaps" or "currency swaps" to lower risks. These swaps can change fixed-rate debts into variable-rate debts or the other way around. They help in avoiding potential issues caused by big changes in currency values, making it easier to repay debts in a foreign currency. Swaps can greatly affect a company's financial records. They help balance and steady the money coming in and going out, along with assets and debts.

Risks of Derivatives

While derivatives can offer advantages, there are also risks linked with these agreements.

Lack of Transparency

A clear instance of derivative risks happened during the subprime mortgage crisis. The failure to recognize and safeguard against the true dangers of investing in mortgage-backed securities led to a series of connected events. Many companies and institutions faced bankruptcy because of poorly managed or structured derivative deals with other firms that went bust.

Counterparty Risk

A big risk with derivatives is the counterparty risk. With these deals, it depends on the other person or institution fulfilling their side of the agreement. If that party faces financial trouble, they might not be able to fulfill their part of the deal.

Leverage

Leverage happens when you use borrowed money to buy investments. Banks and institutions sometimes use lots of borrowed money to make complex deals with derivatives. But if things go bad in the market or with the other party in the deal, the contract might end up being worth very little.

The issue gets worse because many of these deals need extra money or assets if things start going wrong. This happens exactly when the party might not have much money left, making their financial problems even bigger. This situation can lead to bankruptcy and make the problem worse.

When these derivative deals don't work out, it can cause problems for companies, regular investors, and the whole economy, like what happened during the Financial Crisis of 2007 to 2008.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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