What is a derivative?
A derivative is a financial contract between two or more parties that is based on the value of single or multiple assets. The value of a derivative is determined by the changing value of an underlying asset which can be a market index, exchange rates, bonds, commodities, currencies and stocks.
What are the potential risks and rewards of using a derivative in an investment portfolio?
One of the main risks of derivatives is one party not being liquid enough to fulfil their end of the contract. Another is an investor selling below the market rate. This happens when they have already agreed to a price, and then the asset’s value increases to above this price, and they are forced to sell below it, thereby missing out on potential returns.
Investors can use derivatives to protect themselves from a decrease in the value of a commodity. This happens when the investor has a derivative contract that says they can sell to a buyer at a price, and the value of the commodity falls below that price. The buyer still has to buy at a higher price than the prevailing market rate. In this instance, they protect themselves from risks inherent in the financial market.
What are the different types of derivative instruments, and how are they used?
Options are the first type of derivative, giving an investor the right to sell or buy an asset at a specified price in a specified period. The investor can opt out of the deal as there is no obligation to sell or buy.
Futures are contracts that allow their holders to sell or buy an underlying asset at a specified date and at an agreed price. In contrast to options, the contract holder cannot opt out of the deal and has to execute the contract as agreed at the time agreed upon.
Forwards are similar to features with one key difference; they are neither regulated by an exchange nor subject to trading rules and regulations. They are typically customised to fit the needs of the people involved in the contract.
Swaps are derivative instruments where two parties agree to exchange specific financial obligations. Swaps are not traded on exchanges but over the counter, as they are customised to fit the needs of the people parties in the contract.
These derivative instruments can be used for market arbitrage, speculation, risk management, hedging, and to gain market exposure.
How do derivatives impact overall market volatility and stability?
The impact of derivatives on overall market volatility and stability is complex. Derivatives can reduce volatility by allowing investors to hedge their positions and manage risk.
On the other hand, derivatives can also contribute to volatility and instability in the market through leverage. Many derivatives allow investors to control a large amount of the underlying asset with a relatively small investment. This can amplify both gains and losses, leading to increased volatility.
How can derivatives be used to manage risk in an investment portfolio?
Investors can use derivatives to hedge against the fluctuation of the price of the underlying assets where the investor would not be protected from risk if they invested directly.
How do derivatives differ from traditional investments?
First, derivatives provide guarantees that traditional investments do not. Second, investors cannot use margin money to buy traditional investments, but they can do so with derivatives. Third, derivatives are traded between specific parties, while traditional investments are traded between everyone in a market. Lastly, there is less risk exposure when using derivatives than traditional investments unless adequate diversification exists.
What is the difference between forward contracts and futures contracts in the world of derivatives?
Both forward contracts allow two parties to trade an asset at a specified date and price. Their main difference is that forward contracts do not trade on an exchange, while futures contracts are traded daily on an exchange, making them highly liquid.
Derivatives are an excellent option for investors who do not want full exposure to the fluctuation of the market. They allow investors to invest in underlying assets and have serious risks and rewards that all investors should know about.
