8.1 Derivative Markets and Instruments - 8.1 Derivative Markets and Instruments Explained

Key Concepts

• Derivatives
• Futures Contracts
• Options Contracts
• Swaps
• Forwards
• Hedging
• Speculation

Derivatives

Derivatives are financial instruments whose value is derived from the value of an underlying asset, index, or interest rate. They are used for hedging, speculation, and arbitrage purposes. Common types of derivatives include futures, options, swaps, and forwards.

Example: A stock option's value is derived from the value of the underlying stock. If the stock price increases, the option's value may also increase.

Futures Contracts

Futures Contracts are standardized agreements to buy or sell an asset at a specified future date and price. They are traded on organized exchanges and require the parties to fulfill their obligations regardless of the current market price of the asset.

Example: A farmer enters into a futures contract to sell 1,000 bushels of corn at $5 per bushel in six months. The contract guarantees the farmer a sale price, protecting against potential price declines.

Options Contracts

Options Contracts give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price (strike price) on or before a specified date (expiration date). Options are traded on exchanges or over-the-counter (OTC).

Example: An investor buys a call option on a stock with a strike price of $100. If the stock price rises to $120, the investor can exercise the option to buy the stock at $100, profiting from the difference.

Swaps

Swaps are agreements between two parties to exchange cash flows or other financial instruments over a specified period. Common types include interest rate swaps, currency swaps, and commodity swaps. Swaps are typically used to manage risk or to take advantage of differences in interest rates or exchange rates.

Example: A company with a variable interest rate loan enters into an interest rate swap with a bank to convert the variable rate to a fixed rate. This protects the company from interest rate fluctuations.

Forwards

Forwards are customized contracts between two parties to buy or sell an asset at a specified future date and price. Unlike futures, forwards are not standardized and are traded over-the-counter (OTC). They are often used for hedging specific risks.

Example: A manufacturer enters into a forward contract with a supplier to buy 100 tons of steel at $500 per ton in three months. This ensures a fixed price and protects against potential price increases.

Hedging

Hedging is the use of derivatives to reduce the risk of adverse price movements in an asset. By taking an offsetting position in a derivative, investors can protect themselves from potential losses in the underlying asset.

Example: An airline buys crude oil futures to hedge against rising fuel prices. If oil prices increase, the gains from the futures contract offset the higher costs of purchasing fuel.

Speculation

Speculation involves taking on financial risk in the hope of profiting from market movements. Speculators use derivatives to bet on the future price direction of an asset, without necessarily having an interest in the underlying asset itself.

Example: A trader buys a call option on a stock, expecting the stock price to rise. If the stock price does rise, the trader can sell the option at a profit, even if they do not own the underlying stock.