A Beginner’s Guide To Financial Derivatives

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When you think of investing personal finances, there are a few options that seem the most familiar because of practicality and simplicity. For example, many people understand the basic premises of an equity (stock) or a bond and invest them with the idea of holding these assets until their value increases and they can gain a return. These investment options make up a large portion of the investing market, especially amongst the average American family trading on the New York Stock Exchange (NYSE) or Nasdaq.

Exploring Financial Derivatives

On top of these options, some may dive into the real estate market to invest in property, some may predict the future strength of specific currencies to maximize their free cash flow’s value, and some may use these assets as part of a financial derivative.

But what is a derivative? At its core, a derivative is a contract between a buyer and a seller. The difference between a standard contract and a derivative is that the value of a derivative is based on the value of an asset included as part of the contract. This asset be a stock, bond, currency, or even an interest rate — anything that has the potential to serve as a collateral with a specific value or rate at a specific moment in time.

Types of Derivative Contracts

The essence of the contract between the buyer and the seller typically falls under one of three main contract types:

• Option Contracts

  
  

  Gives the buyer the option of buying or selling an asset at a set price for a certain time period, even if the price of the asset changes after the contract is agreed upon.

  
  

  This type of contract benefits investors who believe in a positive future for the asset but want to manage risk and maximize return from the option.

  
  

• Futures and Forward Contracts

  
  

  Futures contract does not allow the flexibility of an options contract; instead, the buyer and seller must agree upon a future date to complete the transaction of the asset

  
  

  This situation is likely to occur if the buyer and seller have different views on the future performance of the asset and both believe they have the better end of the deal

  
  

  A forward contract is the same principal as a future contract but these contracts are traded privately rather than on a public exchange

• Swap Contracts

  
  

  One of the two parties exchanges a fixed rate or currency while the other uses a changing rate or currency.

  
  

  All of these different contracts can only work when there is an agreement between the buyer and the seller, often meaning there is a differing view on the market.

Benefits and Challenges

There are some benefits to using derivatives as an investment. For example, investors can control the asset without too much of a financial commitment, the price of an asset can be protected against strong market fluctuations with a fixed future price, and these options give more diversification and risk management of a portfolio.

Some of the challenges associated with derivatives are the complex nature of the contracts and the transactions, especially considering an uncertain future buy/sell date, and amplified losses or returns based on market fluctuation leading to greater volatility on top of standard market risk.

Overall, derivatives offer a method of investment diversification and speculation that differs from traditional investing and can be used to provide a riskier asset to a portfolio based on future market predictions.

The Bottom Line

Overall, derivatives provide a unique method of investment diversification and speculation, differing from traditional investing and offering opportunities based on future market predictions.

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