Introduction To The Types And Uses Of Financial Derivatives
Financial derivatives are essentially contracts which use a tangible asset as a price
reference (this asset is usually referred to as the underlying asset. For example, one type of financial derivative is an option which gives the holder the right (but not the obligation) to purchase an asset. Thus an option could be granted to purchase Google stock (which would be the underlying asset) at a price of $550 (ie the strike price) prior to the expiry date of December 31, 2015. Options tend to be the most complex financial derivatives to value and trade since there is no certainty that the option will be exercised and a purchase (or sale) will occur.
In contrast, a futures contract is simply a purchase or sale of an underlying asset which is forwarded dated and so a purchase or sale is certain to occur at a point in the future.
The last major type of derivatives is swap contract in which two parties agree to swap cashflows. The most common type of swap is an interest rate swap in which one party pays a fixed rate of interest (such as 5%) in return for an interest rate which varies according to market interest rates.
Financial derivatives can be sold OTC (over the counter) which is just a bilateral contract between two parties one of whom is normally an investment bank and the other an individual or corporate investor. Alternatively, financial derivatives can be exchanged traded and their prices will be quoted on an exchange (such as the NYSE). Exchange traded derivatives are more liquid and can easily traded but do not offer the same flexible terms as OTC derivatives.
Derivatives are often reported as being trading instruments which can be used to take large speculative bets on market movements. And whilst this is a valid criticism, it does ignore the more positive use of financial derivatives - hedging unwanted risks. In the course of their operations, businesses will often acquire risks which they wish to reduce. For example, an airline will want to focus on its core business of providing travel services to its customers but in the course of its business it will acquire a lot of risk related to oil markets since jet fuel is an oil based fuel. To reduce this risk the airline to purchase an option on the oil price, this would allow it to essentially cap the price it will pay for jet fuel.