Quick Overview of Derivatives & How They Work

Derivatives are contracts between two parties, specifying the conditions under which payments are to be made between them.

Think of oil, for example. When people say they are trading or investing in the oil market, do they actually go to the market and buy/ sell oil? No! What is actually traded are the contracts or certificates that are DERIVED from crude oil.

Derivatives are contracts between two parties, specifying the conditions under which payments are to be made between them.

These conditions include dates, resulting values, definitions of underlying variables, the notional amounts, and, the contractual obligations. The assets involved include; stocks, commodities, bonds, interest rates, and currencies. These assets could also be other derivatives.

The essentials of a firm’s capital structure, such as bonds and stock are also considered to be derivatives.

Derivatives are used for increasing exposure to the movements of prices, to enable speculations, insuring against these price movements and for getting access to markets or assets which seem difficult to trade. The functions of derivatives can be broadly classified into two;

Risk Management

Derivatives can be used as a kind of insurance to “hedge” by providing offsetting compensation incase of future undesired events. Risk management is a prudent aspect of financial management and operations across many firms in several industries.

Speculations

Derivatives can also be used to make financial speculations and even a form of financial bet. This risky opportunity offers investors and managers a chance to increase profit, which stakeholders may even be unaware of.

From the economic standpoint, financial derivatives are randomly conditioned and discounted cash flows to present value. The inherent market risk in an underlying asset is added to the financial derivatives through an agreement or contract and can be separately traded.

Derivatives also permit the breakup of ownership and participation in the market value of an asset.

Derivatives can be classified according to:

The relationship between the underlying asset and the derivative: These derivatives are known as forward, option and swap derivatives.

The type of underlying asset: In this case, the derivatives are known as equity derivatives, foreign exchange derivatives, credit derivatives, commodity derivatives, and interest rate derivatives.

The market in which they trade: Here, derivatives are divided into exchange-traded derivatives and over-the-counter derivatives. The over-the-counter (OTC) derivatives such as swaps, which do not go through exchange or other forms of intermediary. Exchange-traded derivatives (ETD) are derivatives traded through specialized derivatives' exchanges or other exchanges.

Derivatives can also be broadly classified into “lock” or “option” products. The “option” products include interest rate swaps and they give the buyer the right to enter the contract under the terms specified. Option products, however, don’t obligate the buyers to the contractual terms.

Lock options, on the other option, commit the parties involved in the contract to the contractual terms as long as the contract lives. These lock products include options, swaps, and futures.

A derivative is a contact which has its value derived from an underlying entity’s performance. The underlying entity, commonly referred simply to as the “Underlying” could be either an asset, interest rate or index.

Written by Lawretta Egba