A derivative can be referred to as a contract that gets or derives its worth from the functioning of the underlying asset. The underlying asset is an index rate or a benefit and commonly referred to as an underlying asset. Derivatives can often be utilized on many platforms and reasons which include hedging, they can also be used to improve the exposure to the changes in costs for speculation purposes and giving traders a platform to acquire assets that are hard to trade.
Commonly known derivatives include:
- Swaps
- Options
- Forwards
- Futures
Many of these derivatives are over-the-counter.
Types of Financial Derivatives
There are different types of derivatives which include the CDO, collateralized debt obligations which were the major reason for the financial destruction in 2008. The worthiness of this type of financial derivative solely depends on the promises of loan repayment. There are two main types which include:
- Asset-backed
- Mortgage-backed
The asset-backed depends on corporate while the mortgage depends on the mortgages. Back in 2006 when the housing market collapsed, so did the mortgage-backed securities together with the Asset-backed commercial paper.
A commonly known kind of financial derivative is the swap which is a concurrence to trade an asset with another, the main initiative is to reduce the chance of risks for the two trading parties, they either use the interest rate of currency swaps.
Credit default swaps are not commonly used plus they were also contributing factors to the financial disaster in 2008. They were purchased by different parties for security against organization debt, mortgage-backed debt and default of municipal grants.
After the market decline of the mortgage-backed securities, there were inadequate funds to pay the holders. The U.S. Government bailed out the AIG(American international group) in a .
Forwards are concurrence to purchase or sell at a cost that has been agreed on, at a specific time. These types of derivatives are used to manage risks in the trading entity and the exchange and interest rates.
Future contracts are another type of financial derivative that is globally utilized to set a specific cost of an item such as gasoline and oil.
Risks Involved in Derivatives
Derivatives also have risks which include:
It is hard to know the actual worth of a derivative since it depends on the specified underlying asset. Their cumbersomeness makes it hard to have a specific cost.
The next risk is also what makes a derivative appealing. Investors can use leverage to borrow securities, traders are required to have more than 2%-10% of the assets to attain the ownership so if the price of the financial derivative increases the investor has to add money to their account.
When dealing with financial derivatives there is a time restriction, predicting the price of a certain commodity will rise or decrease is obvious but knowing the exact time it will happen is hard.
Possibility of scams, traders can be scammed by other traders who are and this can greatly discourage the investor.
Financial derivatives can bring great earnings to the investor if he applies the right and effective strategies and effectively manages all of the possible risks that are associated with derivatives.
