What Are Derivatives in the Financial World & Why People Trade Them

Beyond buying shares, investing has taken on a much more complicated nature with the introduction of various types of financial derivatives in the past few decades.

They are often considered as more advanced trading instruments, but there’s little reason why you shouldn’t get to know them better.

What Are Derivatives?

Derivatives are financial products with values derived from other financial assets and instruments. While a derivative’s value is based on an asset, ownership of a derivative does not automatically mean ownership of the asset.

An example is when you want to invest in gold and bought a gold futures contract. The futures contract gives you exposure to gold price, but owning this contract does not mean that you physically own any gold.

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Types Of Derivatives

Financial derivatives can be broadly grouped into 2 categories – options and forward contracts. In Singapore, 4 main types of derivatives contracts are commonly traded, namely forwards, futures, options and swaps.

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1) Forward Contracts

These are private contracts between parties to buy or sell an asset in the future for a specified price. These contracts are custom-designed and are generally not available in the public domain.

The contracts are usually set in reference to the current price; and, the difference between the current price at time of delivery and the future price is the profit or loss experienced by the purchaser.

These contracts are commonly used to hedge risks, such as currency fluctuations or volatility.

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2) Futures Contracts

Futures work similarly to forward contracts, except that they are standardized and are available for trading via an exchange. Gains and losses are also settled at the end of each day.

In comparison, futures contracts carry less counter-party risk since the exchange stands as an intermediary between two parties.

3) Options

Options give the owner the right but not the obligation to buy or sell a financial instrument at a specific price and date. Options are used both as a way to speculate, as well as to hedge risks.

4) Swaps

Swaps are contracts in which two parties agree to exchange payment streams for a set period of time. The most common swap is a “plain vanilla” interest rate swap.

In this swap, Party X agrees to pay Party Y a predetermined, fixed rate of interest, whereas Party Y agrees to make payments based on a floating interest rate to Party X on that same notional principal on the same dates for the same specified time period.

Essentially, these derivatives help companies manage their exposure to fluctuations in interest rates. On top of that, they are often used because a domestic firm usually receives better rates than a foreign firm.

Why Trade Derivatives?

Most investors use derivatives for 3 main reasons – speculation, hedge risks and to increase leverage. Compared to stocks-trading, derivatives are more risky due to their leverage and more volatile nature.

Those who want to try trading in derivatives should take note of the various risks involved, such as market risk, counter-party risks and liquidity risks.

Always ensure you employ risk-management strategies and understand the nature of the financial derivatives itself before jumping into the trades.

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Lynette Tan

Lynette has more than six years of experience in financial analysis and writing, having stepped foot in the financial world as a commodities analyst. With a passion for personal investing and financial literacy, she hopes to help others gain investment knowledge by making investment concepts plain and simple for the man on the street.

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