What are derivative financial products?
Derivative financial products are possibly the most complex investment assets on the market and also one of the most discussed in the media, especially in times of crisis. Derivatives are very popular in the financial world, yet private investors hardly understand them. That is why we are going to explain them in a clear and simple way.
1.- What are derived products?
derivative products arefinancial instruments whose value derives from the evolution of the prices of another asset, called the "underlying asset". The underlying asset can be very varied: aaction, a basket of shares, a fixed income security, a currency, raw materials, stock indices, etc... The derivative does not have its own intrinsic value, it originates from another financial asset and benefits from its rises or falls. These can be classified into Futures, Options, Warrants, Certificates, Forward Contracts, Swaps or CFDs (Contracts for Difference).
Today there are more than a million derivatives on the market. derivativesThey are traded either in unorganized markets, called OTC(Over the Counter – through the counter) through an intermediary or directly with the issuer,or through the stock market in organized markets. Some derivative products even have their own Exchanges. In Spain, options and futures are traded on MEFF, the Spanish Financial Futures Market, and warrants on the Stock Exchange. The three largest derivatives markets worldwide are the EUREX, the New York Stock Exchange and the CME, Chicago Mercantile Exchange. In organized markets, contracts with a high degree of standardization are negotiated and guarantees are required when it comes to being able to negotiate. In OTC, on the contrary, tailor-made contracts are negotiated between the two parties that carry out the operation, but guarantees are not required. It is a more flexible but less liquid market.
At present, the different types of Derivatives have different levels of risk depending on the leverage effect of the product, soa Derivative can be used both to speculate or to hedge risks.
2.- How do derivative products work?
Basically,a derivative is a forward contract in which all the details are set out at the time of the agreement, while the actual exchange occurs at a future time. We first explain how Derivatives work as speculative instruments.
2.1.- Speculation
A Derivative provides the opportunity to bet on price developments without having to buy the underlying asset. If a person buys a Derivative on the price of oil, because he sees as the price of gasoline does not stop rising and wants to benefit_cc781905-5cde-3194-bb3b_alsocf58d5 those climbs. Suppose that the price of Brent oil, this is the unit of oil on the Stock Exchange, is currently at €100. This person has bought a Derivative for €10, which proportionally replicates the price of Brent oil in a 1:1 ratio. If the price of oil increases by 10% from €100 to €110, your derivative will also increase from €10 to €11. If this person wants to benefit to a greater extent from the price of oil, he can requested at an applied 1 price ratio of oil :10. In this case your Derivative will rise or fall ten times faster than the underlying product. His Derivative is not worth €11 in this case, but €20. Obviously said person assumes a greater risk because in turn he could enter the zone of losses more quickly if the price of oil decreases. Therefore, with derivatives you can bet on price developments, without having to buy the underlying asset, in this case Brent oil.So it's a betin which this person is betting on an increase in the price of oil while others believe that the price of oil will fall and bet against it.
2.2.- Risk coverage
Instead of gambling, tooDerivatives are often used to hedge risks. In financial language it is calledhedge, which means coverage. We are going to suppose that a farmer wants to hedge against the risk of fluctuations in the price of oranges and he wants to do it before the harvest, we are going to suppose 6 months before. He wants to make sure today that he can sell a ton of oranges in 6 months for, let's say, €1,000. In this case, the farmer can buy a Derivative, for example a Future, which guarantees him the right to sell the ton for €1,000. Your counterparty can be, for example, a juice manufacturer, which also wants to protect against price fluctuations, in this case against orange price increases. Both parts have a secure fixed price 6 months before the sale. That set price is no longer changed. If the price per ton of oranges in the market falls, let's say €1,000 to €800, the farmer has done a good deal and wins, because he can sell the ton for €200 more than what he would get if he went to the market . However, if the price per ton of oranges increases to €1,300, then it will be the juice manufacturer, who will have made a good deal, since he can buy a ton for €1,000 instead of the €1,300 that it would cost in the market.
Many companies carry out these risk hedging businesses, especially in the commodity and currency markets, they are very frequent.
3.- What types of derived products are there?
There are several criteria to classify Derivatives. The most useful to distinguish some of the best known is to take ascriterion the firmness of compliancethat is assumed when signing the derivative contract. From this point of view, they can be classified intoderivatives with firm contractandderivatives with conditional contract.
In the previous examples of oil and oranges we hadderivatives with firm contract, which are characterized in that one of the parties undertakes to buy or sell the underlying asset to the other at a future date at a previously agreed price. That is, the exchange is executed on the date and under the agreed terms, without conditions.The farmer has to sell the ton of oranges for €1,000 and the juice maker has to buy the ton of oranges for €1,000 yes or yes.Futures, Forwards or Swaps are examples of derivatives with a firm contract.
In derivatives with a conditional contract, the contract does not serve to agree on an obligation, but rather a right to purchase or sell that can be exercised or not exercised.. The most popular type of conditional contract areoptions, although we find other derivatives in this category such aswarrant ortheconvertible bonds.
Our example with the farmer would be different if he had chosen a derivative with a conditional contract, for example, an Option. Suppose that the farmer buys an Option that gives him the right, but not the obligation, to sell a ton of oranges for €1,000. If the market price is below €1,000 per tonne, for example €800, then it will exercise the right of sale and sell them for €1,000. However, if the market price is higher than €1,000 per ton, say €1,300, then the farmer will not exercise his Option right and will sell the ton of oranges on the market for €1,300. To have the option of having the right, but not the obligation, the farmer must pay a premium to the juice maker, regardless of whether or not he exercises the right to sell.
All this may seem quite complicated and it is not surprising, sinceDerivatives are one of the most complex that the financial world offers.
4.- Criticism of derivative financial products
Given how Derivatives work and what types of Derivatives there are, it is worth knowing that they are quite controversial products and discussed in the media. Not without reason, since it is estimated that the Derivatives market amounts to between 600 and 1,000 Billion Dollars. This means that this market is between 8 and 12 times larger than the world gross domestic product. In other words,there are more risk or speculation hedges than transactions themselves.This is a clear indicator that there are more speculators in the market than people or entities that want to cover their risks.. Speculators are generally not bad, as they provide liquidity to the market and help companies transfer risk. This vision of speculators changes when speculative bubbles form and prices increase artificially. In fact, in the past, banks have been blamed for speculating on the price of certain food products such as wheat or corn, making third world countries unable to afford to buy these raw materials and experiencing periods of famine.