Derivatives Basics

While analysing the derivatives market we need to point out that it has nothing to do with equities and securities. In fact, it is a different financial instrument, which isderived from a particular underlying asset and used to hedge and manage risks. It isalso being implemented in various investment purposes and arbitrage opportunities, which give far better advantages as opposed to equity market (Stefan Mai, 2008).

The definition of a derivative contract says that it is a contract between two parties, a seller and a buyer, which has been set today in regard to a transaction that is going to take place at a future date. As an underlying asset we can accept almost every product type available on the today’s market: whether it will be a transfer of USD at a specified GBP/USD rate at a later date or purchase of OIL for a certain price at some future point in time. Upon signing this contract agreement the derivative price may hover along with the value of the bound underlying asset, which in our case could be both GBP/USD exchange rate and OIL price. Counterparties usually specify time interval of the contract which is between entering the agreement and its final fulfilment or delivery (may take years to go).  Driven by those volatility measurements of both derivative and underlying asset, risk management is an important factor of the counterparty agreement.  As a general rule derivatives contract are not expired within a few days but taking much more time to be fulfilled. We do also have derivatives-like securities like warrants, certificates, but those are not given as a full-fledged derivative asset class, therefore cannot be considered a good hedging tool for the trading activities.

Derivatives can be served as an excellent investment potential for those who are seeking less expensive and risky solutions. When you invest into any derivative, you do not hold the underlying asset itself. It may also give a right to the investors to put money into risk or underlying which is not purchased directly. One of the examples can be credit derivative that guarantees some sort of payoffs or compensation if a sovereign bond gets defaulted. Another one is a classic example on temperature variations where financial derivatives offer a payoff if a temperature level goes above or below a certain reference index. Also, investors are using financial derivatives market as a great tool of protecting risks or even playing against the market if they expect a value drop on a particular stock or asset class. If investors assume it is overvalued or undervalued they may enter a derivatives contract and place a selling or a buying order at a later date. Derivatives are designed specifically for professional traders and holders as the contract’s value vary from $1 to $20 in par. Out of these professionals, financial institutions and corporates make up the majority of all derivatives clients – over 90% for some underlying assets. They can split into two derivative markets – OTC or regulated stock exchanges.

OTC holds contract agreement between two engaged counterparties that may look like a standardized covenant or a customized deal with specialized amendments regarding underlying size, maturity period, contract and other related features. Although maturities are being set by original counterparties, they might be offset prior to expiration. The OTC based derivatives have become a widely used financial instrument – hence new contracts are made on day to day basis. The number of exchange-traded derivatives is also large. Currently over 1,700 units are being listed on the world largest derivate exchanges: Chicago Mercantile Exchange, Eurex and Euronext.Liffe.

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