Financial Derivative: Types & Examples

 We take some overview on financial derivative. In modern financial system risk management is very crucial subject, every one wants to minimize risk in the market or in a contract of buy and sell. The reason behind it is unstable market conditions and fluctuations in price. To minimize risk at that unfavorable situations a trader, an investor wants some instrument and here financial derivative.

 A financial derivative is a contract that derives its value from the performance of an underlying asset, such as a stock, commodity, currency, or an index. The underlying asset can be anything from stocks, bonds, commodities, currencies, interest rates or market indexes.

A derivative contract is an agreement between two parties, where the value of the contract is based on the underlying asset. The two parties involved in the derivative contract are the buyer and the seller. The buyer of the derivative contract is betting on the future price movement of the underlying asset, while the seller is obligated to pay the buyer if the underlying asset moves in a certain direction (as specified in the contract).

Derivatives are financial contracts that derive their value from an underlying asset, such as a stock, bond, commodity, currency, or interest rate. Derivatives are used for a variety of purposes, such as speculation, hedging, and risk management.

One of the key features of derivatives is their ability to transfer risk from one party to another. For example, an investor who is concerned about a potential drop in the stock price of a company can enter into a derivative contract, such as a put option, to hedge against that risk. If the stock price does indeed drop, the investor can exercise the option to sell the stock at a higher price, limiting their losses.

Another important aspect of derivatives is that they allow for leverage, or the ability to control a large amount of an underlying asset with a relatively small amount of capital. This can lead to potentially large profits, but also large losses, so it's important for investors to understand the risks and use derivatives carefully.

It's also important to note that derivatives can be highly complex, and can be difficult for even experienced investors to fully understand. As such, it's important to seek professional advice before entering into any derivative contract, and to carefully consider the risks and benefits before making any investment decisions.

Following are major types of derivative contract:

Futures contract: A futures contract is a type of derivative where two parties agree to buy or sell an asset at a specified future date and price. For example, a farmer may enter into a futures contract to sell his crops at a specific price, to lock in a guaranteed price for his crops in the future, regardless of the market price.

A commodity trader may enter into a futures contract to buy crude oil at a specified price in the future, to lock in a price for the oil that the trader uses in his business.

An investor may enter into a futures contract to buy gold at a specified price in the future, as a hedge against inflation.

Options: An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) within a specified time period. For example, an investor might purchase a call option on a stock, giving them the right to purchase the stock at a specific price, if the stock price rises.

An investor may purchase a put option on a stock, giving the investor the right to sell the stock at a specified price, if the stock price falls.

A company may purchase a call option on a currency, giving the company the right to buy the currency at a specified price, if the currency appreciates against the company's home currency.

Swaps: A swap is a financial derivative where two parties agree to exchange a series of cash flows in the future. For example, a company might enter into an interest rate swap to exchange a fixed interest rate for a floating interest rate, to hedge against changes in interest rates.

A company may enter into an interest rate swap to exchange a fixed interest rate for a floating interest rate, to hedge against changes in interest rates.

An investor may enter into a currency swap to exchange a series of cash flows in one currency for cash flows in another currency, as a way to manage currency risk.

Credit Default Swaps (CDS): A credit default swap is a type of derivative contract that provides protection against the risk of default of a bond or loan. For example, an investor who owns a bond may enter into a CDS contract to hedge against the risk of default of the bond.

An investor who owns a bond issued by a company may enter into a CDS contract to hedge against the risk of default of the bond.

A financial institution may enter into a CDS contract to hedge against the risk of default of a portfolio of loans.

Forward Contracts: A forward contract is a type of derivative contract where two parties agree to buy or sell an asset at a specified future date and price. For example, a company may enter into a forward contract to lock in a future price for a commodity that it uses in its production process.

A company that uses copper in its production process may enter into a forward contract to lock in a future price for copper, to manage price risk.

An investor may enter into a forward contract to sell a currency at a specified future date and price, as a way to lock in a profit from a currency trade.

Cap and Floor: A cap and floor are derivatives contracts that are used to manage the risk of interest rate fluctuations. A cap is a contract that gives the buyer the right, but not the obligation, to receive a payment if a specified interest rate exceeds a predetermined level. A floor is a contract that gives the buyer the right, but not the obligation, to receive a payment if a specified interest rate falls below a predetermined level.

A company may enter into a cap contract to receive a payment if interest rates exceed a predetermined level, as a way to manage interest rate risk.

An investor may enter into a floor contract to receive a payment if interest rates fall below a predetermined level, as a way to earn a guaranteed return on an investment.

Collateralized Mortgage Obligations (CMOs): A Collateralized Mortgage Obligation is a type of derivative that is backed by a pool of mortgage loans. The value of the CMO is derived from the performance of the underlying mortgage loans, and can be used as a tool for managing interest rate and credit risk.

A bank may invest in a CMO, to earn a return from the underlying mortgage loans while managing interest rate and credit risk.

An investor may purchase a CMO as a way to diversify a portfolio and earn a return from the mortgage market.