Derivative financial instruments are called derivatives. They are classified into several types. Derivatives are popular in market economies, especially with the trend towards globalization. It is important to study their features and rules of use.
By definition, a derivative financial instrument is a written agreement between the parties to buy and sell or change the price of the underlying asset with a certain financial result for the parties to the contract, both positive and negative.
Derivative financial instruments have certain properties: maturity, productivity and the ability to use the effect of financial leverage. Urgency lies in the remoteness of the moment of the transaction.
Derivative performance is as follows: the value of the financial result based on the results of transactions depends on the change in the underlying asset or the size of the underlying parameter. Income from futures transactions is the difference between the settlement value of the contract and the current value of the asset in the spot market.
The effect of financial leverage is the possibility of making a profit with less investment than in the market for underlying marketable assets. A derivative is based on a commodity, security, interest rate, or currency.
- Derivative financial instruments include:
- futures;
- forwards;
- options;
- swaps.
Options and futures are exchange-traded derivatives, while forwards and swaps are OTC.
Futures
Futures is a special exchange contract, according to which the owner must sell or buy a commodity in the future. At the same time, the type of goods, its quantity and a specific price are stipulated in the contract.
In order to quickly sell an asset at a market price, delivery conditions, for example, time and place, are separately set for each of the underlying assets. Therefore, participants in the secondary markets quickly and easily find both buyers and sellers.
In order not to receive a refusal from one of the participants in the transaction, it is envisaged to receive a pledge from them. The purpose of such a tool is to minimize risk and consolidate profits. Also, futures serve as a guarantee of delivery. These derivatives are more often without obligation to supply real goods.
Forward
A forward is an agreement for the sale and purchase of one of the underlying assets in the future at a known value. It is traded over the counter and can be negotiated. It should be noted that, unlike futures, no standards are imposed on the asset when forwarding.
This is the simplest of the derivative financial instruments. It is distinguished by the obligation to fulfill, a clear definition of responsibilities for all parties. Forward transactions are not aligned with any specific standards.
Option
An option is a contract that gives only the right, but not the obligation, to the buyer to buy or sell a certain underlying asset within a certain point in time at a specific price. A premium is provided for the seller. To draw up an option, you should know some terms:
- call option - the right to buy;
- put option - the right to sell;
- inscribed - the seller;
- espiration - date of sale;
- strike price - the value of an asset.
Swap
A swap is a contract for the exchange of payments, or rather a set of forward contracts, in which obligations appear periodically. In essence, this is the transfer of an open trade through the night. The result of swaps is an accrued or debited commission. Such transactions are popular in medium to long term transactions. Swaps are not charged during the day.
On weekdays, at the first hour of the night, all open transactions are recounted. This happens by closing and reopening them. Then the swap is charged at the current refinancing rate. The minimum interest is given for such combinations as dollar and euro. The interest rate swap is charged every day.
Use of derivative financial instruments
Derivative financial instruments are used in accordance with the following strategies:
- speculation;
- hedging;
- arbitration.
Speculation
Speculation refers to a deal to receive a premium, which is made up of the difference in the market value of the instrument. The participants in this strategy are speculators. They are an important guarantor of market liquidity and are ready to take on the risks of a transaction.
The environment of the derivatives market is typical for speculation, because in such circumstances there are many opportunities provided by the leverage mechanism. Opening a position on the derivatives exchange market is possible by making a margin or premium. Derivatives enable players to gamble for larger amounts than, for example, an investor.
If we evaluate the ratio of profitability - risk, then it should be noted: the increase in risk is proportional to the increase in potential profit. When the stock market begins to move in the opposite direction, the speculator runs the risk of incurring large losses.
Risk hedging
Hedging means insurance against losses. This strategy means reducing adverse factors for the seller or buyer. This is especially true for companies working with foreign supplier firms, because with a deferred payment there is a risk of unfavorable fluctuations in the exchange rate. Suppliers of volatile commodities such as agricultural products, metals, oil and petroleum products are also involved in hedging.
With this strategy, a contract with a negative correlation in terms of profitability is signed on the derivatives market. Under this condition, a change in price up or down will bring buyers and sellers gains and losses at the same time in different markets.
Hedging is the ability to fix prices in the future. Futures can be sold at a premium or discount, which means you can hedge positions and get an increase in profit by the size of the basis minus costs. The financial result in this case will be equal to the growth or fall of the value of the underlying assets.
With options, the amount hedged depends on the premium at the selected price. Options are less expensive and do not carry many risks. But if you are confident in the future state of the market, it is better to use futures.
Forwards and swaps are the best way to hedge underlying risks. They are flexible about the circumstances of the signing of the contract and allow you to include the desired conditions in the transaction. The difficulty of such derivative financial instruments is to find counterparties with low liquidity of the derivatives.
When hedging with forward contracts, OTC forward transactions are made to buy and sell various assets. In this case, delivery of the index difference by both parties or one of them is possible.
Swaps are used for currency, interest rate, commodity hedging. Commodity swaps facilitate long-term fixation of the buy and sell prices for the buyer and seller, respectively. The purpose of the hedge is to remove future cash flow uncertainties.
Arbitration
Arbitrage means making a profit that can be fixed by playing in opposite positions on the underlying asset in different exchange markets. The derivative nature of the market for financial instruments allows for such transactions. The difference in the value of the underlying asset in the derivatives market at the same time allows an arbitrage transaction to be carried out.
Derivatives are successfully used in the formation of an innovative financial product implemented by financial engineering in various sectors of the economy. Thanks to derivative financial instruments, the modern market has received considerable opportunities for hedging risk, conducting speculative and arbitrage transactions, as well as introducing an innovative product. The development of the field of derivatives contributes to the improvement of the activities of financial market entities.
