What are financial derivatives?
Learn about financial derivatives, including futures, options, swaps, and forwards, and how they can be used to manage risk.
Financial derivatives are financial instruments that are derived from other assets. They allow investors to speculate on or hedge against changes in the value of an underlying asset. Derivatives can be used to manage risk, as they allow investors to transfer the risk of holding an asset to another party.
There are many different types of financial derivatives, including futures, options, swaps, and forwards. These instruments can be based on a variety of underlying assets, such as stocks, bonds, currencies, commodities, and indexes.
Examples of financial derivatives
Here are a few examples of financial derivatives:
Futures
A futures contract is a standardized agreement to buy or sell a specific asset at a predetermined price on a specific date in the future. Futures contracts are often used to hedge against price fluctuations in the underlying asset. For example, a farmer who expects the price of wheat to increase in the future might sell a futures contract to lock in a selling price for their crop. This allows the farmer to reduce their risk of a price decline.
Options
An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. There are two types of options: call options, which give the holder the right to buy the underlying asset, and put options, which give the holder the right to sell the underlying asset.
Swaps
A swap is an agreement between two parties to exchange cash flows based on the performance of an underlying asset. There are many different types of swaps, including interest rate swaps, currency swaps, and commodity swaps. For example, a company that has borrowed money at a fixed interest rate might enter into an interest rate swap to exchange their fixed-rate payments for variable-rate payments based on a benchmark interest rate. This allows the company to manage their interest rate risk.
Forwards
A forward is a customized contract to buy or sell an asset at a predetermined price on a specific date in the future. Like futures, forwards are used to hedge against price fluctuations in the underlying asset. However, unlike futures, forwards are not standardized and are not traded on an exchange. This makes them less liquid than futures.