by Josef A

Created on: June 16, 2009   Last Updated: July 30, 2010

Derivatives are financial instruments that derive from so called underlying assets. A derivate can be related to, among others, a stock, a currency, a whole index, a commodity, a bond, and even other derivatives. Derivatives typically are time-limited rights and allow the purchase or sale of the underlying asset at a certain, predetermined price.

The original purpose of derivatives was to avoid or hedge risk and only actors that had an economic interest would deal with derivatives. A farmer does not know the price his harvest will yield when he starts working on his fields in spring. In order to get more consistency in his financial planning he gets a forward contract, that allows him to sell his harvest in fall for a certain price. The one who sells the forward might be an industrial company processing food. They equally gain planning security through agreeing on such a forward contract.

Most actors that deal with derivatives these days are not economically engaged in the underlying asset. They do not really want to buy several hundred barrels of crude oil in seven months. They want to profit from the price changes by buying the appropriate derivatives. The traders that follow such business are often deemed as speculators. Today, there are an uncountable number of different derivatives on the market, and the number is ever increasing. There are, however, four main types of derivatives, explained shortly in the following:

Forwards: As described in the example with the farmer; the two parties merely agree on a price at a certain point in time and no premium is paid. The contract is binding for both parties.

Options: Grant a right, not an obligation, to the buyer of the option to buy (call) or sell (put) the underlying asset at a certain price at an established time in the future. The option seller gets a premium for issuing the option.

Swaps: Two parties agree to exchange two different streams of incomes of two underlying assets. Typically such swaps are interest rate swaps.

Futures: They are similar to options with the difference that they do not grant a right but are an obligation to buy or sell the underlying asset at a certain time in the future.

This is just a quick overview and many varieties and modifications exist. Pricing derivatives can be very difficult and it requires a lot of time to gain understanding of the mechanism of different instruments. Nevertheless, not only professional actors try to make money with trading derivatives. Many individuals try to profit from the chance to earn quick money with seemingly little effort. However, being successful in the derivate market requires hard work and a sharp mind. Although speculators are often criticized for creating high market volatility infringing on the stability of economies, they provide essential liquidity for trading risk and make markets more efficient.

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