Derivatives have become an essential commodity in today’s complex financial sector. These instruments obtain their worth from other securities for instance, equities, bonds, currency, rates of interest or indexes. Used for risk management at first, subsequently, they become versatile tools for speculation, carrying out arbitrages, and portfolio management.
To get a better understanding of derivatives, this article explores the basics, categories, applications, dangers as well as effects of derivatives on world markets.
What are Financial derivatives?
Financial derivatives also referred to as financial futures are contracts with a third party, where value of the contract is based on the behavior of the subject underlying the contract. Derivatives are strictly different for the conventional financial securities such as stocks and bonds for they do not signify ownership of the base security. Rather, they are a form of the contract with a financial obligation to reciprocate value in relation to the performance of the particular asset during a given period of time.
Key Features
- Leverage: Derivatives make it possible to have high exposure with little amounts of funds needed.
- Risk Management: It is used widely for managing the various financial risks in the marketplace.
- Market Liquidity: Market operation should be eased by reducing price differences.
- Speculation: Provide chances to make money by forecasting market trends.
TYPES AND CONTRACT OF FINANCIAL DERIVATIVES
Futures Contracts
- A futures contract requires from the buyer and the seller to buy and sell specific amount of an asset at a fixed price on a certain future date.
- Futures exist in the organized exchanges, and the product is homogenized in the quality, amount, price, and delivery time.
- Used widely in imported products such as crude oil, gold and other raw materials as well as in stock indices, currencies, etc.
- At a predetermined future date and price.
Example: A farmer uses futures contract to protect himself against future fluctuation in the price of wheat to be delivered sometime in the future.
Options
- Options are the opportunities to purchase or sell an asset for a quoted price in a particular period of time.
- Call Option: Right to buy the asset.
- Put Option: Right to sell the asset.
- While futures have equal gain and loss profile, options have an open-ended gain prospect but an unlimited loss exposure subject to a limited risk exposure of the buyer to the extent of the paid premium.
Example: The owner of capital buys a call option on the stock with a view of a rise in its price.
Swaps
- A swap is the bilateral contract in which two partners agree to receive specified cash flows from each other.
- They include interest rate swaps, where two parties exchange fixed for floating-rate obligations and currency swaps, where two counterparties exchange their original obligations in different currencies for obligations in other currencies.
Example: A debt security that floats uses one type of interest rate to pay for a fixed interest rate to minimize rate risks.
Forwards
- Like futures but forwards are private contracts that are traded on an OTC(over the counter) basis.
- When used, they enable party to set most of their terms thus making the instruments more flexible but less liquid.
Example: An MNC managing operation risk uses a forward contract to mitigate currency risk.
TYPES OF EXCHANGES- TRADED DERIVATIVES
Following are the types of exchanges-traded derivatives:
Stock or Equity Derivatives
- Financial instruments like stock or equity derivatives derive their value from underlying assets like stocks, bonds, commodities, or currencies.
Currency Derivatives
- Currency derivatives also known as financial contracts derive their value from the underlying assets of a foreign currency.
Index Derivatives
- Financial contracts that are based on an index’s performance are Index derivatives. Futures, options, and swaps are the most common types of index derivatives.
FUNCTIONS AND APPLICATIONS
Hedging Risks
- Objective: Protect against unfavorable price movements.
- Hedging financial risks means to use derivatives to fix the price of a commodity and minimize risk.
Example: Oil producers employ fuel futures as hedging tools for their unpredictable jet fuel price swings.
Speculation
- Hedgers bear risks in order to take advantage of changes in prices within the stock market.
Example: Market makers sell options that are expected to become popular prior to the eruption of increased fluctuations in the stock price due to earnings releases.
Price Discovery
- Tender markets, such as future and options instruments may contain expected prices as a convenient for players in the form of futures and options.
Arbitrage
- Arbitrageurs specifically work in a process of searching for market inefficiencies to make sure risk-free profits in the process.
Example: Bargaining an asset in one location and selling its derivative at a higher price in another location at the same time.
RISK ASSOCIATED WITH DERIVATIVES
Market Risk
- It also exposes you to high risks in the sense that a poor performance in the underlying assets can work to the detriment of your portfolio significantly.
Counterparty Risk
- In OTC derivatives, one counterparty’s distress affects the other counterparty.
Liquidity Risk
- Certain derivatives do not have an active market, and this creates difficulty when making the exit.
Operational Risk
- Pricing mishap, wrong settlement, or execution results in the loss of money.
Systemic Risk
- Covered in section 5: The failure of the financial derivative market in the 2008 financial crises pointed out how one can easily affect the other.
HISTORICAL PERSPECTIVE
Origins
- Derivatives have origins under the ancient Mesopotamian civilization, where farmers used forward contracts on food grains.
Modern Development
- The Chicago Board of trade was established in 1848 thereby promoting futures trade in the market.
- The use of options trading was however spearheaded by the formation of The Chicago Board Options Exchange (CBOE) in 1973.
The 2008 Financial Crisis
- Speculative instruments such as CDOs and CDS which are very difficult to understand were used inappropriately during the crisis.
REGULATION OF DERIVATIVE MARKET
Pre-2008 Era
- Lack of regulation and, notably, OTC derivatives let for speculation and non-transparent operations.
Post-Crisis Reforms
Regulatory frameworks like the Dodd-Frank Act in the U.S. introduced:
- Hedging requirements for non-standardized OTC contracts.
- Use of trade repositories as a means of improving transparency.
- New measures include; Higher capital standards for financial institutions.
Global Coordination
- The risk is managed through contract bodies such as the International Swaps and Derivatives Association (ISDA) that has developed standard contracts and recommended practices.
ADVANTAGES OF FINANCIAL DERIVATIVES
Efficient Risk Transfer
- Accommodate those with high or low risk tolerance level for exposures.
Market Efficiency
- Increase flow and efficiency of the price discovery process.
Access to Global Markets
- Allow investors to invest in overseas markets and balance most of the portfolios.
Cost Efficiency
- The use of derivatives as hedge is cheaper than other hedge strategies such as divestiture through sale of assets.
CHALLENGES IN DERIVATIVES MARKETS
Complexity
- Derivatives are complex and difficult to value thus their appreciation calls for expertise and sophisticated models.
Speculative Excess
- High leverages have a potential of causing huge losses and more especially so to the unsophisticated investors.
Regulatory Arbitrage
- Harmonization of policies is another issue due to the inconsistency of policies between various countries or regions of the same country increased risky exercises.
Systemic Impact
- Over-sighting in derivative by some big giants of the financial industry can create global crises.
TRENDS IN THE DERIVATIVES MARKETS
Technological Advancements
- Blockchain: Enhanced transparency as well as decreased settlement period.
- AI and Machine Learning: But these machines improve trading prospects and also help in risk management.
Sustainability Derivatives
- Carbon credits and renewable energy derivatives fund ESGs (Environmental Social and Governance).
Crypto Derivatives
- The Foreign exchange markets also show that there is a huge demand for exposure to digital assets through increased trading in bitcoin futures and options as well as Ethereum futures and options.
Retail Participation
- Derivatives are available even in platforms such as Robinhood and Zerodha to an individual customer.
CONCLUSION
Financial derivatives are indispensable products with great influence on risk management and investment. But they are a ‘double edged sword’ and can enhance opportunity as well as risk.
Though as instruments for gaining hedging and profitable opportunities, derivatives favor market efficiency, occurrence of severe consequences results from misuse of such instruments. The use of these technologies must be balanced between innovation and regulation and education in order to unlock their potential and avoid system risks.