Defining financial derivatives

Defining financial derivativesA derivative is that financial contract whereby its value is derived from an underlying asset’s performance. Now, anything ranging from currencies and stocks to indices and interest rates can be known as an underlying asset. In contracts of derivative, the commodities also used often are gold and oil. Although over some decades back, derivatives importance has had its’ rise, they could still be traced to some centuries back. As early as the eighteenth century, rice futures had their trades in the Osaka region of Japan.

Now, there are quite some purposes the derivatives have their use, e.g. To insure against the movements of price also called hedging, speculating, or gaining access to assets that are difficult to trade otherwise. It is said simply that the derivative contract buyer agrees to buy on a certain date later and at a price that has been agreed to, the Underlying Asset.

There are three major categories of instruments used in finances which are formed by the debts and stocks together with the derivatives.  Furthermore, they can be divided into the “option” and “lock” derivatives.  The option and future derivatives can have their trades exchanging while forwards and swaps derivatives have their trades over the counters.

There exist many derivatives types, but those commonly used include:

 (i) swaps. (ii) forwards. (iii) options. (iv) futures


The swaps can be said to be derivative contracts whereby two parties come to an agreement of exchanging each other’s financial instrument flow of cash. These various cash flow streams are referred to as swap contract legs. At the initiation time of the swap contract, equity prices, foreign currencies, floating interest rates etc. determines single cash flows usually.


 The forwards have similarities like futures except for the fact that their trades are down over the counters and also not with standards.


 Options are contract for financial uses which present not an obligation but a right of the buyer to sell or buy the underlying asset, not like futures. This is done on a particular future date and at also the price agreed to. Now, the obligation to attain the requirements of the contract is had by the seller once the buyer has decided to enforce the option. Hence, that price agreed to by the duo parties is known as Strike Price.

Options have their contracts grouped into the “call” and the “put” options depending on the right of the buyer to either sell or buy the underlying asset.

Put: This “options” grants the right of being able to sell at a particular Strike Price, the underlying asset to the seller.

Call: This options itself grants the buyer the right to buy at a particular Strike Price, the underlying asset.


Futures can be known as forward contracts which have been standardized and thus have made obligations to the contractual parties in order to sell or buy at the price agreed to, the underlying asset at a certain time later. The underlying asset’s visional price is known as Forward Price and the futures contract’s specific time is known as Delivery Date. This underlying asset usually is an instrument of financial use like a pair of currency or stock and can even be a commodity like gold or oil. Originally, futures were used in hedging against the fluctuations of prices by making letting one to put prices for a specific future date.

Financial derivatives variations – Credit Default Swap (CDS) and Collateralized Debt Obligation (CDO)

A swap contract whereby the contract’s seller has made an agreement of compensating the buyer if there is a default in the loan is known as Credit Default Swaps. The seller receives various payment series known as “CDS fee”, and receives back, the loan’s face value if a loan default occurs.

Financial derivatives variation whereby different assets are brought together and packed again into some tranches which investors buy are known as the Collateralized Debt Obligations. Primarily, the assets that have been pooled are made up of obligations of debt like mortgage and loans, bonds and the tranches of the CDO vary especially in their own risk profiles depending solely in case of any default on the advantage on the collateral of the debt.

Limitations of derivatives

Every investor should be totally alert of derivative contacts characteristics as in order to lower their risks as derivatives have underlying securities broad ranges. Additionally, investors have to note their counterparts’ risks and the price and expiration date of the contract.

Derivatives are subjected also to a number of limitations in regard to their nature. A good example is when investors make use of derivative contracts frequently like the forwards or futures in hedging and diverting their various portfolio, assuming a correlation that is negative exists between some classes of other assets and the underlying asset. However, with time correlations could even vary or change completely hence, the leaving an investor at a risk higher than how he would have been without using a derivative contract.

Lastly, derivatives usually are focused on great leverages in order to make investors acquire from little price movements, huge returns. But then, price losses can also be increases significantly by leverages when predictions made by the investor have been moved against by the price.

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