Financial derivatives are financial contracts linked to the value of an underlying asset. They are considered advanced financial instruments used for a variety of purposes, from speculation to generating potential returns. These instruments are effective in hedging and provide a means of accessing additional assets and markets for investment. The value of financial derivatives is derived from the current value of the underlying asset, and this value changes based on market conditions. Financial derivatives are used to predict the movement of the underlying asset in the future, enabling investors to achieve gains or reduce potential risks. These instruments vary in form and include futures contracts, call and put options, and futures contracts. Financial derivatives form an essential part of advanced investment strategies and play an important role in improving the efficiency of financial markets.
Types of financial derivatives:
There are multiple types of financial derivatives, and each type differs in its terms and purposes. Here is an explanation of some of these types:
- Futures: Futures contracts are agreements between a buyer and a seller to buy or sell a specific commodity at a future time at a specified price.
- OTC futures contracts: Futures contracts are similar to futures contracts, but the main difference lies in where they occur and their negotiability between the two parties.
- CFDs: Used to exchange the difference in the value of the underlying asset, where the difference between the opening and closing price of the contract is determined.
- Options contracts: It gives the buyer the right to enforce the contract, but is not obligated to do so. The buyer agrees on the price and date on which the contract can be executed.
- Swap contracts: It is more complex, as the parties agree to exchange future cash flow according to a pre-determined formula, and is used to protect the parties from various risks.
When it comes to swap contracts, they are usually not traded on exchanges and are negotiated between the parties involved, and investment bankers are the main intermediaries in these transactions.
Advantages of financial derivatives:
- Risk Management: Financial derivatives are mainly used to hedge risks, as individuals and companies can use them to limit fluctuations in the value of the underlying assets and potential negative impacts.
- Determine the price of the underlying asset: Specifying the price of the underlying asset is used in derivative contracts, such as futures, to provide an approximation to the price of a commodity and enhance transparency in the market.
- Supporting market efficiency: Financial derivatives enhance the efficiency of financial markets by providing opportunities to replicate asset returns and balance actual prices with those derived from derivatives.
- Access to unavailable assets: Financial derivatives can help institutions access assets or markets that may not be available to them directly, contributing to enhanced portfolio diversification.
- Possibility of using leverage: The possibility of using leverage is one of the notable features of derivatives trading, as investors can enter larger trades with less money, increasing the potential for higher returns. However, caution must be taken to avoid incurring significant losses.
Disadvantages of financial derivatives:
Despite the benefits of financial derivatives, they may pose some drawbacks and challenges, and clear examples of this were recorded during the financial crisis that occurred in 2007-2008. Disadvantages of financial derivatives include:
- High risk of high volatility: Financial derivatives may be subject to significant price fluctuations, which increases the financial risks for investors. These fluctuations can arise from unexpected changes in market or economic conditions.
- Speculating on the markets: Financial derivatives may heighten speculation in financial markets, as investors can use them to bet on market trends without having an underlying investment attached.
- Counterparty risk: The use of derivatives involves dealing with a counterparty, and there may be a risk that the counterparty will not be able to fulfill its obligations, which will have a negative impact on the financial performance of the contracting parties.
- Sensitivity to supply and demand: Financial derivatives may be affected by changes in market supply and demand. In some cases, sharp fluctuations in supply and demand can reduce the effectiveness of derivatives strategies.
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