by Catherine Perez

Created on: March 27, 2009   Last Updated: March 30, 2009

Derivatives are extremely sophisticated financial tools and as such only professionals should handle them.They are financial contracts between two parties, whose value is linked to an underlying security. The underlying security can be many things: an asset (equity, commodity), or an index ( stock market indices, interest rates) etc. There are many types of derivatives, but the most common are the following:

- Forwards

- Futures

- Options

- Swaps - Contracts for difference

Before I elaborate on the subject, I'd like to explain why financiers feel the need to use derivatives. Derivatives are used for both hedging and as high risk investments.

Hedging is a financial strategy designed to minimize one's exposure. The investor will offset the risk of one security by buying or selling another one. For instance, imagine that a farmer wishes to sell in advance his crop to a wholesaler in order to remove the price uncertainty. (futures contract) So he would for a predetermined price agree to deliver a predetermined amount of his crop to the wholesaler. The wholesaler is removing the risk to not have the amount of stock he requires. They are both hedging.

However, the risk has mot been waved entirely, the farmer still runs the risk to not have any crop to deliver for any given reasons. The wholesaler potentially is buying the crop at a higher price.

High risk investment, high return. By trading derivatives the investor in theory positioned to make much more profits then if he was trading the underlying asset. This is speculation. You assume that the value of the underlying asset will move in the direction you expect it to. But because the reward is great, the risk taken is equally great. Novice are setting themselves up to failure, and many who despite all warnings take the plunge have seen their savings disappearing in a puff of smoke.

Now that you know in broad terms what are derivatives, let us explore with more details their different forms:

- Forwards:

They are very similar to Futures in the sense that this contract determines the buying or the selling of a given quantity of a specific asset at a specified future date at a pre-determined price. Forwards are part of Over the Counter Derivatives and are trading and negotiated privately. - Futures They function like forwards but are standardized and traded publicly on exchanges. - Options They allow their holder to exercise the right (not the obligation) to either sell or buy (depending on the type of option) an asset. This contract is limited in time. -

- Swaps:

They are agreements to exchange one stream of cash flows for another. For instance an investor could switch financing a currency for financing in another. I could also be used in the case of interest rates. One could swap a floating rate for a fixed rate. use to finance

- Contracts for Difference, CFD are also pretty similar to futures, only they cannot be settled at delivery. Two parties agree to pay a certain amount of money depending on the change in some numbers. Many investors CFD as another form of gambling.

At the risk of repeating myself, I would like to once more warn you from the risks of such investments. I strongly recommend that you stick to common stock trading if you wish to enter the Wall Street game and that you leave derivatives for the likes of Warren Buffet..

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