Financial Derivatives 2024 2025

FINANCIAL DERIVATIVES
What are derivatives?
Derivatives act as contracts whose value comes from some underlying asset related to
it, and all across the country, they are used to trade and make money.
Derivatives serve as financial contracts of a kind, in which their value depends on

some underlying asset or a group of such assets. Some of the most commonly used
derivatives are bonds, stocks, commodities, currencies, and indices. Since the value of
the assets which control the derivative value fluctuates occasionally, the derivative does
not have a fixed value. Market conditions play an important role in deciding the value of
a derivative. The basic guiding principle of derivative trading is that the buyer
successfully predicts market changes to earn profits from their contracts. When the price
of the asset on which the derivative depends falls, you will meet with a loss, whereas a
surge in price, results in a profit. Therefore, trading in derivatives is about being able
to predict the rise and fall of the asset and timing your exit and entry into the market
subsequently.
Why invest in derivative contracts?
Earning profits is not the only reason investors flock towards derivative contracts. One
of the biggest reasons investors prefer derivatives is because it gives them an Arbitrage
advantage. This comes as a result of buying an asset at a low price and then selling it at
a higher price in another market. This way, the buyer is protected by the difference in
the value of the product in the different markets, and thereby, gets an added benefit from
both markets. Furthermore, certain derivative contracts protect you from market volatility
and help shield your assets against fall in stock prices. If that wasn’t enough,
derivative contracts are also a great way to transfer risk and balance out your portfolio.
Participants of the derivatives market
1. Hedgers:
Risk-averse brokers and traders who wish to play it safe in the stock market.
Rather than invest in tricky stocks which may give them either a huge profit or a
huge loss, hedgers invest their money in derivative markets, in a bid to protect
their portfolio. By assuming an opposite position concerning the derivatives
market, they can protect themselves against market risk and price fluctuations.
2. Speculators:
They are the primary risk-takers of any derivative market as they don’t mind
taking risks to earn large profits. Therefore, they have a frame of mind that is
the polar opposite to the one possessed by hedgers, who wish to play safe always.
3. Margin Traders:
Margin is the bare minimum that an investor needs to pay the broker to take part
in derivatives trading. This margin is a form of representing market fluctuations
as it reflects the loss or gain made on that day.
4. Arbitrageurs:
They make use of market imperfections to make money by buying low-priced stocks
and then selling them at higher prices in a different market. However, this
becomes possible only if the commodity in question is priced differently in
different markets.
Advantages of Derivatives
1. Hedging risk exposure
Since the value of the derivatives is linked to the value of the underlying asset,
the contracts are primarily used for hedging risks. For example, an investor may purchase
a derivative contract whose value moves in the opposite direction to the value of an asset
the investor owns. In this way, profits in the derivative contract may offset losses in
the underlying asset.
2. Underlying asset price determination

Derivatives are frequently used to determine the price of the underlying asset. For
example, the spot prices of the futures can serve as an approximation of a commodity
price.
3. Market efficiency
It is considered that derivatives increase the efficiency of financial markets. By
using derivative contracts, one can replicate the payoff of the assets. Therefore, the
prices of the underlying asset and the associated derivative tend to be in equilibrium to
avoid arbitrage opportunities.
4. Access to unavailable assets or markets
Derivatives can help organizations get access to otherwise unavailable assets or markets.
By employing interest rate swaps, a company may obtain a more favorable interest rate
relative to interest rates available from direct borrowing.
Disadvantages of Derivatives
1. High risk
The high volatility of derivatives exposes them to potentially huge losses. The
sophisticated design of the contracts makes the valuation extremely complicated or even
impossible. Thus, they bear a high inherent risk.
2. Speculative features
Derivatives are widely regarded as a tool of speculation. Due to the extremely risky
nature of derivatives and their unpredictable behavior, unreasonable speculation may lead
to huge losses.
3. Counter-party risk
Although derivatives traded on the exchanges generally go through a thorough due diligence
process, some of the contracts traded over-the-counter do not include a benchmark for due
diligence. Thus, there is a possibility of counter-party default.
Reference:
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/derivatives
Major Derivative Types
FUTURES FORWARDS SWAPS OPTIONS

Definition Standardized contract to Customized OTC contract A contract where two A contract that gives the
buy/sell an asset at a to buy/sell an asset at a parties agree to exchange holder the right (but not
future date and specific future date and cash flows or financial the obligation) to buy or
predetermined price, price. instruments over time. sell an asset at a
traded on an exchange. predetermined price
before a specified date.
Trading Venue Traded on organized Over-the-counter (OTC), OTC or cleared through a Traded on both exchanges
exchanges (e.g., CME, customized between two clearinghouse, depending (standardized) and OTC
NYSE). parties. on the type of swap. (customized).
Standardization Highly standardized in Customized based on the Can be standardized (for Standardized on
terms of contract size, needs of the two parties interest rate or currency exchanges; customizable
expiration dates, and involved. swaps) or customized in OTC markets.
underlying assets. (OTC).
Settlement Usually settled through a Settled directly between Settled periodically based Settled upon expiration or
clearinghouse, reducing two parties, increasing on the terms of the swap exercised before
counterparty risk. counterparty risk. agreement. expiration by delivering
the underlying asset or
cash.
Counterparty Risk Low, due to High, as there is no Depends on the type of Low for exchange-traded
clearinghouses acting as clearinghouse involved, swap, but often involves options; higher for OTC
intermediaries. raising default risk. counterparty risk unless options due to
cleared. counterparty risk.
Purpose Primarily used for hedging Used for hedging or Used to manage interest Used for hedging and
and speculation on asset speculation, especially for rate, currency, or speculation, allowing for
prices. specific, customized commodity price risks. the right to buy/sell an
needs. asset without obligation.
Leverage High leverage due to small High leverage, as a small Swaps often involve high Leverage varies
margin requirements initial margin can control leverage depending on depending on the
relative to the contract a large position. the agreement terms. premium and strike price.
value.
Regulation Regulated by financial Less regulated as they are Regulated if cleared Exchange-traded options
exchanges and oversight private agreements through exchanges; OTC are highly regulated; OTC
bodies (e.g., SEC, CFTC). between parties. swaps may have less options are less so.
regulation.
Example A wheat futures contract A forward contract An interest rate swap A call option giving the
on the Chicago Board of between a company and a where one party pays holder the right to buy
Trade (CBOT). bank to buy foreign fixed and the other pays shares of Apple stock at a
currency in six months. floating. specific price before
expiration.
References:
References
Hull, J. C. (2018). Options, futures, and other derivatives (10th ed.). Pearson.
Mishkin, F. S., & Eakins, S. G. (2015). Financial markets and institutions (8th ed.). Pearson.
Chance, D. M., & Brooks, R. (2015). An introduction to derivatives and risk management (9th ed.). Cengage Learning.

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FINANCIAL DERIVATIVES

What are derivatives?

Derivatives serve as financial contracts of a kind, in which their value depends on

Why invest in derivative contracts?

Participants of the derivatives market

2. Underlying asset price determination

Major Derivative Types

FUTURES FORWARDS SWAPS OPTIONS

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