The financial market is a dubious field of gain and risk where investors trade in stocks, derivatives, forex and other financial instruments. The derivatives market, in particular, is gaining prominence, with the global derivatives market size expected to reach 39170 million USD by 2027.
A security with a price based on or derived from any number of the underlying assets is a derivative. An agreement between several parties based on the asset or assets constitutes the derivative itself. The two main uses of financial derivatives are speculation and investment hedging.
This article will explore some of the most popular derivatives in the financial market and how investors use them.
What are derivatives?
Derivatives are financial instruments that derive value from an underlying asset, such as commodities, stocks, bonds, or currencies. They are used for various purposes, including hedging against price fluctuations, speculating on future prices, and arbitrage.
The underlying asset's price determines a derivative's value, but the derivative itself is a separate and distinct financial instrument.
For instance, a company that relies on a particular commodity might use a derivative contract to lock in a price for that commodity to mitigate the risk of price fluctuations. On the other hand, an investor might use a derivative contract to speculate on the future price of an asset or to take advantage of price differences between different markets.
6 trending derivatives
Trading carries potential risks from market fluctuations, varying currency exchange rates, etc. However, investors trading in the derivatives market can earn substantial profits through appropriate predictions. If used correctly, derivatives can act as safety nets and help mitigate losses in the spot market.
Here are six popular derivatives and how investors use them:
Futures are agreements between two parties to buy or sell an underlying asset at a specified price and time in the future. Investors use futures to hedge against price fluctuations, speculate on an asset's future price, and arbitrage price differences between markets.
Options provide investors with the right to buy or sell an elementary asset at a specified price and time in the future. However, once bought, buyers are not obligated to hold on to the agreement terms of the contract. Investors use options to hedge against price fluctuations, speculate on the future price of an asset, and generate income through selling options.
These are agreements between two parties to exchange cash flows based on different financial instruments. Investors use swaps to hedge against interest rates, currency, or credit risk, speculate on future interest rates, or create synthetic assets.
CFDs (Contracts for Difference)
CFDs are agreements between a seller and buyer to exchange the difference between an underlying asset's closing and opening price. Investors use CFDs to speculate on price movements in various financial instruments, including commodities, stocks, indices, and currencies.
ETFs (Exchange-Traded Funds)
ETFs are investment funds that trade on stock exchanges and track the performance of an underlying index or asset. ETFs help investors gain exposure to a diverse range of assets, hedge against market risks, and speculate on the future direction of markets.
CDS (Credit Default Swaps)
CDS are insurance-like contracts that protect against a bond or loan default. CDS are useful in hedging against credit risk, speculating on the likelihood of default, and trading on the creditworthiness of companies or countries.
Using derivatives in investment can offer several benefits, including:
Hedging against price fluctuations
Derivatives can be used to hedge against price fluctuations in underlying assets, reducing the risk of losses for investors.
Generating higher returns
The possibility of higher returns than traditional investments makes derivatives an attractive option for investors looking to increase their portfolio returns.
Derivatives can diversify investment portfolios, spreading risk across various asset classes and reducing overall portfolio risk.
Speculating on market movements
Derivatives can be used to speculate on the future direction of markets, providing opportunities for investors to profit from price movements in underlying assets.
Efficient use of capital
Derivatives require less capital than traditional investments, allowing investors to use their capital more efficiently and potentially generate higher returns.
While derivatives offer many benefits, they can also be complex and carry significant risks.
It is important for investors to carefully consider their investment goals and risk tolerance before using derivatives. Investors should also thoroughly understand the underlying assets and the risks associated with derivative contracts.
Derivatives can be a powerful tool for managing risk and generating returns. They are a great way of earning high profits at low investments. However, they come in varying complexity and require careful consideration.
With a thorough understanding of the underlying assets and the risks associated with derivative contracts, investors can use derivatives to effectively manage their investment portfolios and achieve their financial goals.
If you are interested in the derivatives market and aspire to build a career in finance in India, you can check out Imarticus’s Certified Investment Banking Operations Professional course.