What Is A Financial Derivative?

What Is A Financial Derivative

Are you a beginner looking forward to trading financial derivatives like the seasoned traders? Or an expert with the intent of broadening your knowledge of this subject? A derivative is a financial instrument that obtains its value from an underlying asset. These assets could be commodities, precious metals, bonds, stocks, interest rates, credit, Forex, and Equities. Read on to find succinct information about these products, types, things to consider when choosing a broker for your trading aspirations, and how best to trade financial derivatives.

MARKET EFFICIENCY

Derivatives can suitably increase the efficiency of financial markets because they have to do with many arbitrations. This process helps reveal the actual value of the underlying asset. The contract prices and that of the underlying assets remain in equilibrium, hence opposing arbitrage opportunities.

SPECULATION

Traders use derivatives for speculation and are mainly motivated by profit, rather than a desire to mitigate risk, in contrast to hedging, where they seek to limit risk by using derivatives as insurance policies (to attempt to indirectly increase profitability).

RISK MANAGEMENT

Managing risk, otherwise known as hedging, is taking a position in a related and uncorrelated security with the intent of mitigating against opposite price movements. Using derivatives has helped major financial institutions and governments simplify their risk elements that investors can trade.

What is the derivative market?

The derivative market structure is classified into two, the exchange-traded derivatives market and the over-the-counter derivatives market. The market makers make money through the bid-ask spread and interact with different parties. If a given party A says they want to take a long position, then the market maker will take the opposite position and then find a party B with whom the market maker will take a long position. The amount at which the market maker will buy is called the bid price, and this is lower than the asking price. The difference between these two figures is called bid-ask spread and is where the market maker makes some of their profits.

Participants in the derivative markets are the Hedgers (eliminate the risk associated with an asset’s price using futures and options market). The speculators get extra leverage in betting on an asset’s future movement using futures and options contracts. Arbitrageurs look to take advantage of the inconsistency between prices in two different markets.

Types of derivatives

There are many types of derivatives, including Contract for Differences (CFDs), the Forward, Futures, Options, and Swaps.

CONTRACT FOR DIFFRENCES, CFDs

Arguably, CFDs are the most common type of financial derivatives. Its popularity comes as a result of its vast benefits; however, not without risks. A CFD (contract for difference) is a contract between a trader and a broker where both parties agree to trade underlying asset’s price differences during the time the contract starts and ends. This financial instrument allows the trading of a product without the obligation of owning the asset. Traders can enter significant trading positions with small capital called margin. Traders can also take advantage of rising and falling in the asset’s price by “long-selling” and “short-selling” depending on their speculation. CFD instruments includes currency pairs, cryptocurrencies, commodities and stock indices.

FORWARD AND FUTURES

A forward derivative is a customized contract between two parties to purchase or sell an asset at a certain price on a future date. This contract can be tweaked to any level depending on the requirements of both parties. The contract applies to commodity type, date of delivery, delivery location, contract size, and settlement currency.

Similar to the forward contract, the futures contract is also an agreement between two parties to buy or sell an asset at a predefined date in the future at a pre-decided price. While futures are traded on an exchange, forwards are traded over the counter. Futures are standardized contracts, whereas forwards are customized. They require an initial margin and are more liquid, but forwards do not require an initial margin and are less liquid.

OPTIONS

Options derivatives are the financial products that give the holder the right to buy or sell the underlying asset at a predefined price at a predefined future date. Options are of two types, the call option, which gives the holder the right to buy the underlying asset at a specific price on a certain date. And the put option gives the holder the right to sell the underlying asset at a certain price on a specific date. The option buyer pays the premium and can buy/sell the underlying asset. In contrast, the seller of the option receives the premium and is obligated to buy/sell the underlying asset in line with the options buyers’ requirements.

SWAPS

Swaps are financial derivatives where the two parties exchange (swap) the future cash flows. It is the exchange of one security for another, based on different factors. For example, a borrower of a floating rate loan swapping with a borrower of a fixed-rate loan.

How to trade derivatives

MetaTrader 5 is often considered to be one of the best trading platforms for trading derivatives on thousands of financial markets worldwide. At the same time, derivatives can be traded on an exchange and over the counter. However, the significant difference between these two is standardization. In contrast, the exchange contract is highly standardized; the over-the-counter (OTC) contracts are customized and tailored to meet the two parties’ needs. In addition to security, you’d want to look out for a broker with a good history and industry-leading trading platforms to start trading.

Final Words

Risk is a characteristic feature of all the commodity and capital markets. Derivatives came into being primarily to eliminate price risk. The derivative is a financial instrument contract whose pay-off structure is determined by an underlying asset’s value. They are specialized contracts which are employed for a variety of purposes, including reduction of funding cost by the borrowers, enhancing the yield on the asset, modifying the payment structure of the asset to correspond to the investor market will. Because of the substantial risk involved, potential traders must understand how these products work for successful trading.

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