What are derivatives: their types and meaning. Features of derivative transactions and risks for investors
The financial literacy of most novice investors comes down to knowledge of basic financial instruments such as currency, securities, precious metals. In fact, the choice is wider. In addition to the main investors use derivative financial instruments, among which it is worth highlighting derivatives.
Concept and purpose
Derivatives are called derivatives because their value depends on the price of the underlying asset.
In simple words, a derivative is a contract according to which one party undertakes to transfer to the other a pre–agreed asset for a certain amount of money and exactly within a specified period. The underlying assets in the conclusion of derivative transactions are: currency, raw materials, stocks, bonds, market indices, interest rates.
The purpose of using derivatives is to reduce market risks. This is achieved due to the fact that the parties pre-negotiate the terms of the transaction.
Types of derivatives
There are three large groups of derivatives, depending on the type of underlying asset:
- currency;
- stock;
- commodity.
According to the type of contract , there are:
- futures, which represent an obligation to make a transaction in the future without the right to refuse to execute it. The underlying assets of futures are usually raw materials, securities, currency, various commodities, precious metals, monetary obligations;
- forwards are the same as futures, but traded on the OTC market;
- options that differ in the ability to refuse to make a transaction, since this derivative is a right to purchase, not an obligation;
- swaps, which are transactions for the exchange of payments on mutually beneficial terms. By means of an option, one side is insured in case of a fall in price, the other in case of growth.
Where derivatives are purchased
An ordinary investor can purchase various types of derivatives on the futures departments of stock exchanges. For example, the Chicago Mercantile Exchange.
To purchase a derivative, you need to choose a reliable broker, open and top up an account, decide on a PFI and purchase a profitable contract. At first glance, everything is simple, however, experienced investors recommend initially undergoing basic training and learning strategies.
Features of derivative transactions
Experts recommend paying attention to the following features of derivative transactions:
- a derivative is always dependent on the underlying asset, it cannot exist independently;
- such transactions are characterized by a fixed price and the urgency of the contract;
- warranty that protects the seller from non-fulfillment of obligations by the buyer;
- high risks;
- relatively high profitability.
Investor risks
Among the main risks, experts distinguish:
- credit related to the use of leverage and non-fulfillment of obligations;
- risks caused by possible failures in the operation of trading platforms;
- legal issues arising from incorrect paperwork or bankruptcy of one of the parties;
- the risk of a decrease in the liquidity of the underlying assets, as a result of which the demand for derivative financial instruments also decreases.
But the main risk of derivative transactions is the probability of incurring significant losses, up to the formation of debt to the broker, if the asset price falls. At the same time, when the price increases, the investor can get unlimited profit.
Published: 25 November, 2022
