ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel
  • »
  • Personal Finance»
  • Understanding Finance

Financial Derivatives - A Simplified view

Updated on September 6, 2016

Derivatives - What does the term mean

Derivatives. Ever stop to think of the word's meaning? I am sure you would have heard the term, either in relation to Chemistry, or Finance or even in General Parlance. So what does 'derivative' mean? Simply put, It means something which is derived from something else. So then, what is a financial derivative, and what properties does it derive from where?

A financial derivative is something which derives its value from an underlying Financial asset. The underlying Financial asset can be stock, currency, a commodity(such as Gold, Silver, Iron, Wheat etc.) or even an Interest rate prevailing in the market. The value of the Financial Derivative is always dependent on the value of its respective underlying asset. For eg. Consider the following scenario. A wheat farmer has, say, 1000 bushels of wheat to sell. Lets say that he is expecting the price of wheat to go up in around a week's time. But also, he has some apprehension that, there is a slight chance that the prices might go down as well. So now, what does the farmer do? He can enter into a Forward Contract, which is a Financial Derivative Instrument. As per the forward contract, he can lock-in a price for his wheat. The other party(counterparty) to the contract promises to buy the quantity of wheat specified in the contract, at the specified future date, at the Lock-in price. Since the general market perception in this case is that the price of wheat is expected to go up, the lock-in price will be higher than the current price in the market(spot price.) So how does the farmer benefit here? He has locked in a price which is above the price he would get, were he to sell in the market at the current rate, Also he has safeguarded himself against a possible decrease in price in the future. Of course, if the price goes above the lock-in price, the Farmer's gain is less than what would have been had he waited to sell the wheat in future. However, here, he is at least assured of a gain. This example depicts one of the reasons why a Financial Derivative is used, viz. Hedging against risk.

Futures, Forwards and Options

A Forward contract is just one form of a Financial Derivative. There are other Derivative instruments like Future Contracts, Options etc. A Futures Contract is a contract which is regulated by the exchange as opposed to a forward contract which is non-regulated. A futures contract is thus, more secure, as there is no chance of the counterparty defaulting. However, a Forward contract is a more customized instrument, whereas futures contracts are standardized instruments.

An option, as the name suggests provides an option to the buyer of the option, to either buy or sell (a commodity, or shares of a stock, or a Foreign currency etc.) at a future date at a pre-specified rate. It is different from a contract in that the buyer of the option has an option to buy or sell, but is not obligated to do so. However, the seller of the option is obligated to sell/buy should the buyer of the option opt to exercise his option. The buyer of the option has to pay an option premium to the seller of the option. The seller of the option hopes that the option will not be exercised, whereas the buyer hopes that market situations will favour exercise of the option.

In a nutshell

The example of the wheat farmer represented one of the purposes served by a Financial Derivative, viz Hedging against risk. There are two other main purposes - Speculation and Arbitrage. More of these in subsequent blogs. Also more to follow on the different types of Futures and Forward Contracts and the types of options.

A Financial Derivative is a complex Financial Instrument to be entered into with requisite knowledge and caution. This is because the magnitude f losses in some Financial Derivative contracts is very huge. However, wise use of Financial Derivatives can help hedge against possible Financial risk and hence increase profitability.

Comments

    0 of 8192 characters used
    Post Comment

    No comments yet.

    working

    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, hubpages.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: "https://hubpages.com/privacy-policy#gdpr"

    Show Details
    Necessary
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
    CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
    Features
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Marketing
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Statistics
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)