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Introduction to Financial Derivatives
Getting Started in Hedging or Speculation in the Secondary Market
Apr 8, 2009 © Michael N. Delahunt
A derivative is a price guarantee in an exchange between two parties.
It has no intrinsic value but derives value from something else,
such as some underlying commodity.
Derivatives are often referred to as "financial instruments". One may think
of many different reasons for using derivatives, but they are used
for just one of two basic functions:
Hedgers use derivatives to manage uncertainty, to reduce financial risk ‐ the prospect that price might
"move against" an asset, such as a commodity. Speculators use derivatives not to reduce financial risk
but to potentially profit from them, to purely wager their bets and (hopefully) gain from the leverage
of the financial instrument.
Derivatives have a
gambling aspect as evidenced by their history.
Trading Derivatives
Derivatives allow traders to earn large returns from small movements in the underlying asset's price and
these speculators could lose large amounts of money if the price of the underlying commodity moves against
them significantly. However, losses can be limited by exiting the market with a stop loss order as part
of the trader's trading plan.
Main Elements of a Financial Derivative
A financial derivative is an agreement between a future buyer and a future seller. The common elements
of all derivatives are:
- Buyer and Seller
- Underlier
- Future Date
- Future Price
Types of Derivative Contracts
Some derivatives are so simple that they are called "vanillas" while complex derivatives are hard to
understand and are called "exotics". All derivatives, no matter how exotic, are variations or
combinations of just four basic types:
- Forward Contract - is an agreement to buy something at a specified price on a specified
future date.
- Futures Contract - is a standardized forward contract executed at an exchange, a forum
that brings buyers and sellers together.
- Swap Contract - is an agreement to exchange future cash flows.
- Option Contract – grants its holder the right, but not the obligation to buy or sell
something at a specified price, on or before a specified future date.
Forwards, Futures and Swaps commit their parties to a future transaction, whereas options do not.
Options are the only contracts with any inherent value upon inception. Because futures and options
are exchange traded, they tend to be more liquid and fungible (one as good as another) than are
forwards and swaps.
Derivative Markets
There are two basic types of derivative markets:
- The over-the-counter (OTC) market is where two parties find each other then work directly
with each other, to formulate, execute, and enforce a derivative transaction.
- The exchange market is where buyers and sellers can deal and not worry about finding each
other in a feature known as liquidity. Examples of exchange markets are: Chicago Board of Trade,
New York Mercantile Exchange, Sydney Futures Exchange.
Pricing Derivatives
Derivative prices are often expressed in the form of a quote, which is just a price at which someone
is willing to buy (bid) and sell (ask or offer). The difference between bid and ask for a given contract
is often called the bid-ask spread, as illustrated in Figure 1 below. A quote with size includes the
number of contracts in an order.
When complex markets move so fast,sometimes offer prices are not greater than bid prices. But not for
long. There's no shortage of arbitrageurs ready to "pick off" such bargains just as fast as they appear.
Common Underliers
Every derivative specifies a future date on or before which the transaction must occur and a future
price at which an underlier can or must be sold. An underlier is a term referring to the underlying
physical market. It may be a commodity such as corn or natural gas, or some financial security such as
stock or a government bond, or a price index.
References:
- "All About Derivatives – The Easy Way to Get Started." Michael Durbin. McGraw-Hill,
NY. 2006
The copyright of the article Introduction to Financial Derivatives is owned by
Michael N. Delahunt. Permission to republish in print or online must be granted by the author in writing.
Figure 1. Concept of the Bid-Ask Spread
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