Derivatives, i.e. ...

Derivatives are financial contracts whose value depends on the price of the underlying instrument. This means that the derivatives themselves have no value, because it is closely related to the underlying assets, so it depends on the share price, currency, index, interest rate, bond yield, index or other indicator, e.g. inflation or GDP value. In other words, derivatives are abstract contracts that allow you to take advantage of price changes in the market without actually owning the asset.

A characteristic feature of derivatives is that they relate to future prices and dates, as contracts concerning them are concluded earlier in order to obtain the right to receive a certain monetary value or the obligation to make a transaction. Transactions in derivatives can be concluded on stock exchanges, over-the-counter markets and directly between two entities – then we are talking about OTC (overt-the-counter).

The most important derivatives are options, futures, forwards and swaps. What are the characteristics of individual derivatives?

• Options

Options give traders the option (but not the obligation) to buy or sell the underlying asset at a selected date and at a set shadow. Importantly, if the investor decides to sell or buy them, the seller is obliged to make the transaction at the agreed price. Options are primarily designed to hedge positions against unfavorable and sudden price changes, but also to enable speculation.

• Futures and forwards

Futures contracts are standardized exchange agreements that oblige both parties to execute a transaction at a specific time and price. Forward contracts are non-standardized and are concluded directly between the parties, which allows the terms of the contract to be tailored to their needs and requirements.

• Swap

A swap is an agreement between the parties that sets out the terms of mutual payments. The amount of payment depends on a specific indicator, e.g. the interest rate. Swaps are mainly used to hedge against financial risks or to change the structure of financial flows.

Types and classification

Financial instruments can be divided into types according to different criteria, making it easier to understand their diversity and application in the financial market. The basic classifications concern the type of underlying instrument (shares, bonds, raw materials), the method of settlement (cash or physical) and the place of trading, but derivatives can also be divided according to the risk incurred or the degree of complexity. Types of instruments by underlying instrument:

• equity derivatives – allow you to profit from stock fluctuations without having to physically own them;
• bond derivatives – used mainly for interest rate risk management;
• foreign exchange derivatives – the underlying instrument is a currency, which allows you to benefit from exchange rate fluctuations;
• commodity derivatives – futures for natural resources are particularly popular on the commodity market, which allows you to invest in commodity prices;
• index derivatives – the underlying instrument is a stock market index;
• interest rate derivatives – the underlying instrument is an interest rate, a bond, or a debt instrument, e.g. a treasury bill.

Types of instruments by settlement method:

• cash – settled only in cash;
• physical – settled by physical delivery of goods. This is of great importance for the real needs of the market and is used on the commodity exchange.

Types of instruments by place of trading:

• trading on the stock exchange – these are exchange derivatives, e.g. futures and options;
• Trading on over-the-counter markets – e.g. forwards and swaps.

Division of instruments according to the benefits achieved and costs incurred:

• symmetrical instruments – each party to the contract bears the same risk, but also receives the same profits. These are primarily swaps and futures and forward contracts;
• asymmetric instruments – one of the parties to the contract bears a higher risk. These are, for example, options.

Types of instruments by complexity

• first generation instruments – standard derivatives;
• second-generation instruments – are a group of derivatives based on other derivatives.

Instrument Features

Derivatives can perform a variety of functions in the financial market, the most important of which is hedging against adverse price movements. For example, exporters can hedge their future income in foreign currencies against the risk of adverse changes in exchange rates, and farmers can secure contracts for certain goods, hedging against falling prices. And how to do it... This is what we talk about on our training platform.

Derivatives also provide the opportunity to speculate on changes in the prices of the underlying instruments using options and futures, which allows you to profit from price changes. Additionally, they can act as leverage – investors have greater investment opportunities with relatively small initial capital. However, this involves a lot of risk, but with skillful management, it can lead to significant profits.

Derivatives also contribute to the liquidity of financial markets. The ability to trade high-volume futures and options makes the market more efficient. For investors themselves, derivatives are a great way to reduce risk and increase profits, as they make it easier to control exposure to various types of risks related to changes in prices, interest rates and rates, which is exactly what we talk about on Webinar Universe.

Derivatives and risk

The most important purpose of derivatives is the transfer of risk, not the transfer of capital, as is the case with other instruments (shares, bonds). This allows you to minimize the risk associated with investing. However, it should be remembered that each form of investment is burdened with a certain risk, which is closely related to the market situation and the volatility of the prices of the underlying instruments. In addition, in the case of swaps, there is a risk that the other party to the transaction will be insolvent. It is impossible to completely predict changes in the market, but skilful portfolio management allows you to significantly reduce risk and can bring large profits. However, it is important to know that the risk associated with derivatives is relatively small, as long as you have the appropriate knowledge and experience in investing and the time to follow market changes.

Derivatives are used by experienced investors to diversify their investment portfolio and reduce the risk associated with investing. Their value is directly related to the prices of assets such as stocks, currencies or raw materials. Derivatives provide the opportunity to protect against sudden price changes and speculate on the future prices of selected underlying instruments without the need to physically own them. Investing in derivatives involves some risk, but their skillful use can bring large returns on investment. If you have difficulties choosing the right financial instruments, it is worth using the services of an advisor or broker. We analyze this topic in detail during training on Webinar Universe.