July 31, 2014

Derivatives Explained

Derivatives are a type of investment in which their value is derived from other underlying investment. For example, the value of a derivative is commonly based on fluctuations in the valuation of another factor, such as exchanges rates or interest rates.

Broadly speaking, the two most common types of derivatives are those which are either forward or option based. These derivatives can usually be traded Over the Counter (OTC) or through an exchange. The major difference with OTC exchanges is they can usually be tailored more between those parties involved than those derivatives traded on an exchange.

Forward Derivatives

A forward derivative binds an investor to complete a transaction at a future specific date. Once a forward derivative deal is initiated, there is a usually a legal requirement to complete the transaction unless both parties specifically agree to cancel it. Typically, there is no premium charged for this type of deal. Sometimes, forward derivatives are known as ‘futures’ on an exchange and can cover market indices as well as commodities.

Over the Counter Forward Derivatives can include foreign exchange contracts, or ‘forwards’ for short. Under a foreign exchange contract, a client must purchase a specific amount of currency at a specific rate in the future. This allows them to combat the risk of the currency moving against the favour, but also has the disadvantage of now being able to capitalise should the currency move in their favour.

Option Derivatives

The key difference with an option difference is that you have a right, but not an obligation to complete a transaction within a defined period. Another key difference is that options are typically charged at a premium or rather up-front charge for this luxury. Call and Put options are used depending on whether a party wishes to buy or sell a security at a particular rate within a specified time-frame respectively. The key benefit of this is that you provide yourself with security should things move against you, but at the same time leave you free to benefit from favourable movements.