DERIVATIVES

WHAT ARE DERIVATIVES?

A derivative is a security with its price based on the performance of one or more underlying assets. Fluctuations and price changes of the underlying asset determine the value of the derivative. When investors purchase a derivative, they only indirectly invest in the underlying asset. Thus, they only take part in the development of the underlying asset as agreed upon in the contract.

The following financial products can serve as an underlying asset:

  • Shares
  • Bonds
  • Currencies
  • Commodities
  • Interest rates
  • Market indexes

Legally, financial derivatives are debt securities of a credit issuer. However, its value does not depend on the credit rating of the issuer but rather on the derivative’s relation to the underlying asset’s value.

Derivatives are mostly traded on an exchange or also over-the-counter (OTC). OTC derivatives are more common and not under regulation, whereas those available on the exchange are under supervision of regulatory bodies. OTC traded derivatives are thus considered to be more risky.

TYPES OF DERIVATIVES

There are several types of derivatives as it is considered a category of security. Depending on their type, derivatives may have a multitude of purposes. Some may be used for hedging or serve as an insurance for riskier assets. Derivatives are also traded specutalotory when betting on a future asset value. When trading with multiple currencies, derivatives are also used in order to bypass any exchange rate issues.

Types of derivatives:

  • Futures contracts - A contract between two parties for the sale of a financial instrument at a specific price and time period.
  • Forward contracts - Forward contracts are similar to futures contracts, only that they are traded OTC only.
  • Swaps - A contract to trade loan terms or swap interest rates.
  • Options - A contract between two or more parties including the option to buy/sell the asset at a set future date. However, the sale is optional.
  • Credit derivative - A contract entailing the sale of a loan lower than its actual value
  • Mortgage backed security - The underlying asset is a mortgage loan.

ADVANTAGES OF TRADING DERIVATIVES

Even with smaller investments, investors can profit greatly from the performance of the underlying asset. This financial instrument may mitigate risks associated with trading other assets. In the event of stock market prices falling, trading derivatives successfully can be used in order to limit or offset price losses. Derivatives can also be used by companies to hedge against fluctuations in exchange rates or commodity prices. Derivatives can be implemented for more complex investment strategies.

RISKS

The key of any investment strategy is to fully understand all risks associated with the financial instruments.

The risks associated with derivatives include the following:

  • Lack of transparency of offers and costs
  • Counterparty
  • Underlying assets
  • Price fluctuations
  • Expiration

Generally speaking, trading derivative is not suited for a long term investment strategy but rather short-term speculations in order to maximize profits or avoid high exchange rate losses. In addition, private investors should be aware that they may incur a total loss of their investment. Furthermore, trading futures may result in an unlimited loss due to risking margin calls. Inexperienced investors should thus stay wary with trading derivatives. Especially trading Forex with currency pairs can result in the highest losses. Potential forex traders are advised to use online demo accounts prior to investing capital. Hedging, in particular, is associated with high risks because exchange rate losses may increase significantly. It is thus advised to only trade with small funds. Only private investors who have fun in financial betting and who can afford incurring losses should trade in derivatives.

Summary:

  • Derivatives: A financial product whose price and value development depends on the underlying asset
  • Investors can limit or offset price losses, take advantage of exchange course differences, make large profits by leveraging small amounts of funds
  • Contract between several parties about the sale of the financial product at a predetermined price and date
  • The following can serve as underlying assets: Shares, bonds, currencies, commodities, interest rates and market indexes
  • A distinction is made between fixed and swap transactions. Options with derivatives can be set to rising or falling prices, which can protect a portfolio against losses in value.
  • With a great profit potential comes greater risks. Traders and investors should understand the functions, conditions and consequences of trading.
  • Trading derivatives at the stock market is not advisable for beginners. Only experienced traders are advised to trade derivatives