In this article, we will tell you everything you need to know about financial derivatives. What are financial derivatives? Definition, types and common examples – we will cover it all.
What Is a Financial Derivative?
A financial derivative is a contract that is valued based on the kind of asset it is related to. That is just a definition, so if you do not get it, worry not. We are here to make you understand.
So, an asset is anything that has a positive value, right? Well, a derivative takes the value of an underlying asset – like stocks, bonds, indexes, etc. – and derives a value out of this asset. This derivative takes the form, usually, of forwards, futures, options of swaps. These are the four main kinds of financial derivatives.
Here is an example. Suppose you are playing poker. Whatever you win at poker is the underlying asset. Your friend makes a bet based on how much you are liable to win. His bet is dependent on your win. In other words, his income is derived from the underlying asset. That is how financial derivatives work, in a nutshell.
These derivatives are then used for trading and being available from financial brokers the world over. Derivatives are what keeps the market alive.
What Are the Different Kinds of Financial Derivatives?
There are four types of financial derivatives that you will run into in finance, as we discussed above. In this section, we will describe each of them in turn to gain a better understanding.
An options contract is one that gives you the right, not the obligation, to buy or sell an asset at a specific price. This can be at or before the predetermined date. What this basically means is that you can choose to buy a certain thing at a certain price in the future.
Go for an options contract if you like to buy low and sell high. You will need to be flexible and know the right time to sell for maximum profits. That is when an options contract will make itself useful to you.
As the name suggests, a swaps contract allows you to exchange assets with another person in a way that is beneficial for both parties involved. This usually involves tradable assets like bonds, for example.
Since they involve the exchange of assets, swaps contracts can get very complex and convoluted. In fact, swaps contracts are the most complex among the four major derivatives. Thus, this is all you need to know for now – no point in getting your understanding all muddled at this stage.
In complete contrast to the last point, a forward contract is the simplest kind of derivative that we have in finance right now. It is also the oldest. Basically, a forward contract is nothing but an agreement between two parties to buy and sell something at a later date. The price at which this transaction is to take place is to be recorded and set at the present time.
The good thing about a forward contract is that the terms of the deal that they reached are privileged information for both parties. They are under no obligation to release this information to anyone.
Building off of the previous point, a futures contract is basically a forward contract with an added rider: the contract can be traded amongst people who were not involved with the initial contract. This is unlike a forward contract, where the contract stays between two parties forever.
Other than that, it works just like a forward contract. The parties decide to buy and sell something at a later time at a price they decide upon at the time of making the contract.
Finance is complicated. No matter how much you see people claiming to make investments simple or that understanding derivatives is easy, the truth is anything but. It is a vast frontier, and there are a lot of risks and complications involved.
However, it is our mission to at least try and make sense of this beautiful world of finance and hand you bite-sized pieces to absorb in chunks. Our goal is to teach you to be smart about investments and, with this article, we hope we have been able to get at least one step closer to achieving that.