Financial Derivatives: Definition, Types, Risks

A financial derivative is a financial asset whose value is derived from changes in another asset, called the underlying asset.

The financial derivative originates from the underlying asset. That is the asset that generates it. For example, the financial future on gold. The financial future is the financial instrument, while gold is the underlying asset.

There are a multitude of possible underlying assets: raw materials, indices, fixed-income and equities, interest rates, interbank rates (Euribor, Libor…).

Characteristics of a financial derivative

Other characteristics of a financial derivative are:

  • Does not require a large initial investment, or this is very small in relation to the investment required if you wanted to trade directly with the underlying asset.
  • It is generally settled at a future date. That is, in the term.

Types of financial derivatives

The main types of derivatives are swaps, futures and forwards, and options.

In the following table we have made an outline of financial derivatives, in which we can see the different products classified according to their respective underlying assets, market types and type of derivative:

Underlying asset Types of Financial Derivatives
Organized markets OTC markets
Futures Options Swap Forward Options
Stock index Future on the IBEX Option on the future value of the IBEX Equity swap Back-to-back n/a
Type of interest Future Euribor Option on future Euribor Interest Rate swap (IRS) Forward Rate Agreement (FRA) Interest Rate Cap and Floor
Basis swap
Bonds Bond future Option on bonds Asset swap Repurchase agreement Option on bonds
Actions Stock future Stock option Equity swap Repurchase agreement Stock
Foreign exchange FX future Option on FX future Currency swap FX forward FX option
Credit risk n/a n/a Credit default swap (CDS) n/a Credit default option

Derivatives are as old as trading, let’s see some examples:

«In chap. 29 of the book of Genesis in the Bible, around 1700 BC It is already mentioned that Jacob bought an option to marry Raquel in exchange for seven years of work for his future father-in-law Laban… ».

‘The first known’ ordered ‘transactions were on the Royal Exchange in London. Which allowed to contract the future, towards the middle of the 17th century, a time when futures on tulips were negotiated

“There are also references to rice futures contracts in Osaka, Japan in the mid-17th century, where more than 1,300 rice traders had been registered.”

Main uses of financial derivatives

The main uses of derivative instruments are:

  • Hedge: To reduce or eliminate the risk derived from the fluctuation of the price of the underlying asset. For example, a farmer and miller who enter into a futures contract on the sale of grain at a certain price, to avoid possible increases / decreases in the price of grain.
  • Speculation: The intention is to obtain a profit due to the expected differences in the prices, minimizing the contribution of funds to the investment. It should be borne in mind that due to the high degree of leverage they entail, the multiplicative effect on both possible gains and losses is very important. Note: The orderly participation of speculators in the markets is not necessarily negative, as it provides them with liquidity, depth, stability, helps efficient pricing, and in many cases acts as a counterparty to someone who performs a hedging transaction.
  • Arbitration: A genuine arbitrage operation is based on the execution of a cross exchange strategy in which a positive net profit is produced. They tend to be short-term in nature and are due to market inefficiencies.

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