8 Derivatives - 8. Derivatives Explained

Key Concepts

• Derivatives
• Forwards
• Futures
• Options
• Swaps
• Hedging
• Speculation
• Arbitrage

Derivatives

Derivatives are financial contracts whose value is derived from the performance of an underlying asset, index, or other financial instruments. They are used for various purposes, including hedging, speculation, and arbitrage.

Example: A stock option is a derivative because its value is based on the underlying stock's price.

Forwards

Forwards are customized contracts between two parties to buy or sell an asset at a specified future date and price. Unlike futures, forwards are not standardized and are traded over-the-counter (OTC).

Example: A farmer and a cereal company agree to sell a certain amount of wheat at a fixed price six months from now to manage price risk.

Futures

Futures are standardized contracts to buy or sell an asset at a future date and price. They are traded on organized exchanges and require margin deposits to ensure performance.

Example: An investor buys a futures contract for crude oil on the NYMEX exchange, agreeing to purchase oil at a set price in three months.

Options

Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price (strike price) before or at a certain date (expiration date).

Example: An investor buys a call option on a stock with a strike price of $50, giving them the right to buy the stock at $50 before the option expires.

Swaps

Swaps are contracts in which two parties exchange cash flows or other financial instruments. Common types include interest rate swaps and currency swaps.

Example: Two companies enter into an interest rate swap where one pays a fixed rate and receives a floating rate, while the other does the opposite, to manage interest rate risk.

Hedging

Hedging involves using derivatives to reduce the risk of adverse price movements in an asset. It is a strategy to protect against potential losses.

Example: An airline buys futures contracts on jet fuel to lock in prices and protect against future price increases.

Speculation

Speculation involves taking on financial risk in the hope of profiting from market movements. Speculators use derivatives to bet on the future direction of an asset's price.

Example: A trader buys call options on a stock expecting its price to rise, hoping to profit from the increase.

Arbitrage

Arbitrage involves taking advantage of price differences in different markets for the same asset. Derivatives are used to exploit these discrepancies and lock in risk-free profits.

Example: A trader buys a stock on one exchange and simultaneously sells a futures contract on the same stock on another exchange, profiting from the price difference.