A type of complex financial contract, a derivative is an instrument that receives its value from an asset, benchmark, or asset group. These assets can be stocks, currencies, commodities, bonds, interest rates, market indices, and cryptocurrencies. A popular trading method, the derivatives market is the stomping ground for anyone interested in investing, from teenagers armed with the right app and enough spending money to multimillion-dollar investors.
Generally, derivatives are traded in one of two ways, through a derivatives market (Chicago Mercantile Exchange) or over the counter (OTC) through a broker-dealer. OTC derivatives are not regulated or standardized, unlike exchange-traded derivatives. While OTC derivatives might yield more profit, there is more risk.
The four main types of derivatives are futures, forwards, swaps, and options. A futures contract involves two parties agreeing on the purchase of an asset to take place at a specific price and date. Forward contracts are similar to futures, except forward contracts are set up OTC.
Options operate in the same way where two parties agree to buy/sell an asset at a specific price and time. However, in the case of options, the buyer is under no obligation to use the contract. Because the buyer is under no obligation, investors pay a premium, usually a fraction of the agreement's value.
Finally, swaps allow the exchange of cash flow and liability to decrease costs or generate profits, mainly with interest rates, commodities, currencies, and credit defaults. Swaps usually come with high counterparty risk and are accessible to financial institutions and companies instead of individual investors.
Investors use derivatives for a few reasons, one being to hedge risk against the value of an investment. They also allow the investor to customize their stock that can be used for specific trades.
Finally, derivatives allow investors to invest in assets that might not be accessible financially. For example, a tech company with shares that cost several hundred dollars might be too expensive for a small-time investor. However, derivatives options will allow the person to invest a fraction of the amount to yield some gains if stock prices increase.
Credit derivatives are used to hedge and speculate (profit from price fluctuations) in terms of credit derivatives. They are also used in arbitrage or the buying/selling of the same asset in different markets to generate money from price differences.
The credit derivative transfers credit risk in layman's terms, such as operational, market, and liquidity risk. Furthermore, they are sold OTC, so most businesses that use credit derivatives are institutional (non-retail), and when a retailer does use credit derivatives, it is more speculative. Two basic types of credit derivatives are credit default swap (CDS) and collateralized debt obligation (CDO).
The CDS allows the investor to transfer risk to another market participant. If the person lending the money is worried about the borrower defaulting, the lender can buy a CDS to offset the credit risk. Like an insurance agreement, the CDS acts as an insurer to the lender if the borrower defaults.
The advantages to the CDS are that they absorb shock during a corporate crisis, increase liquidity (ability to turn assets into cash), and be an indicator of a borrower's financial health. Conversely, their disadvantages are that the contracts can be manipulated, encouraging speculation.
In addition, the CDO allows banks to structure asset-back securities comprised of portfolio bonds, bank loans, and mortgage and non-mortgage-backed securities, among others instruments used to reduce risk. Its advantages are that they increase the flow of credit in the economy, transform illiquid assets into liquid ones, and provide options for investors at different risk levels. Alternatively, their disadvantages include they create liquidity problems, and they can culminate in lax lending standards.
pixelskylines
baratheonpilled
yousharknotpass
jacobvanloon
jbbartram-illu
stormborns
annaxmalina