Financial Derivatives - A Simplified view
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.