We often hear about derivatives in the trading world, but what does this term mean? A derivative gives the buyer the right to buy or sell something at a certain price. The value of a derivative depends on the underlying value, such as the value of a stock, commodity or foreign currency.
Known financial derivatives
- Futures, CFDs and Forwards: these are the purchase of a product in the future.
- Options: give the possibility, but not the obligation, to buy something in the future.
- Swaps: pairs swap certain cash flows with each other.
The derivative product
A derivative is a financial instrument whose value is derived from the trade of an actual product. For example, an apple farmer can sign a contract with a trader for his entire crop before there is a single blossom to be found in the trees. The agreed-upon price for the crop will be lower than when the farmer has a peak yield, but a lot higher than it would be with a failed crop. Derivatives prevent large financial setbacks.
What risks do derivatives cover?
Derivatives can be used to cover any cost that fluctuates greatly, such as the price of fuel of an airline, or the income of a large company such as Heineken. With housing associations the interest rates that fluctuate can be covered.
To protect themselves from large fluctuations in interest rates, corporations usually use swaps. A swap is a form of derivative where you trade your own variable interest rate with a party that has a similar interest rate that is fixed. When the interest rate differs too much from the fixed rate the losing party has to be compensated.
The bank that mitigates the transaction usually demands that such an amount is paid in full through margin calls. This way the bank is able to prevent the paying party from going out of business.
Other types of derivatives
There are other types of derivatives that are used by interest-sensitive companies. You could use something called a ‘swaption’ as a company. This is a kind of contract that requires the parties to setup a swap in the future.
If it comes to it, the situation may have changed and the agreed-upon terms are no longer valid. In this situation you need to pay more to issue the swap.
Caps and floors
Corporations use caps and floors a lot. These are derivatives where the interest is determined within certain parameters. Parties that issue such a derivative pay a little extra if the interest rate goes outside of the parameters. These derivatives are usually very pricey, but are very good for the peace of mind of the management team.
Derivatives are derived products that protect a trader from large financial risks or setbacks that they can’t cover themselves. It’s also possible to trade derivatives for profit. You can do this with a broker.