In finance, a financial derivative or simply a derivative is a contract that derives its value from the performance of an underlying entity. Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded on the financial markets in their own right.
This underlying entity may be an asset, an index, or an interest rate , and is often simply referred to as “underlying”. Derivatives can be used for various purposes, including insurance against price movements (hedging), increasing exposure to price movements for speculation, or accessing assets or markets that would otherwise be difficult to trade.
Financial derivative transactions should be treated as separate transactions and not as integral parts of the value of the underlying transactions to which they can be linked. The value of a financial derivative is derived from the price of an underlying item, such as an asset or index.
Unlike debt instruments, no principal amount is advanced to repay and investment income is not accumulated. Financial derivatives are used for a number of purposes, including risk management, hedging, arbitrage between markets, and speculation.
Summary
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- 1 Story
- 2 Definition
- 3 Speculation and arbitration
- 4 Examples of derivatives
- 5 Examples of derivatives markets
- 6 Applications in Cuba
- 1 Example of future sugar prices
- 7 Global applications by governments
- 1 coverage
- 2 Speculation
- 8 Lush and structured derivatives
- 9 See also
- 10 Source
History
The oldest example of a derivative in history is believed to be a contractual olive transaction , entered into by the ancient Greek philosopher Tales, and witnessed by Aristotle , who made a profit on the exchange.
Definition
A derivative is a financial instrument whose price is derived from the value of one or more underlying assets, liabilities, or indices. Two general types of derivatives are privately traded contracts, called over-the-counter derivatives and standardized derivatives that are often traded on the exchange.
Speculation and arbitration
Derivatives can be used to acquire risk, rather than hedge against risk. Therefore, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking the insurance will be wrong about the future value of the underlying asset. Speculators are looking to buy an asset in the future at a low price under a derivative contract when the future market price is high, or to sell an asset in the future at a high price under a derivative contract when the future market price is lower.
Individuals and institutions can also seek arbitrage opportunities, such as when the current purchase price of an asset falls below the price specified in a futures contract to sell the asset.
Derivative examples
Derivatives are one of the three main categories of financial instruments, the other two are stocks and debt (bonds and mortgages ). Some of the more common derivatives include forwards, futures , options, swaps and variations of these.
Examples of derivatives markets
- Eurex Exchange (Deutsche Börse)
- London International Financial Futures and Options Exchange (LIFFE)
- Tokyo Financial Exchange (TFX)
- Chigaco Mercantile Exchange (CME)
- New York Board of Trade (Intercontinental Exchange, ICE)
Applications in Cuba
Derivatives, especially options and futures , reduce the risk that the underlying will lose value (with a cash offset) that affects Cuban ministers in global transactions. Cuban ministers who trade with foreign companies and institutions through financial markets make use of derivative instruments for the benefit of Cuba . Ministers, for example MINCEX among themselves, use derivative instruments to protect themselves from the risk of unforeseen changes in the global economic environment for the good of the Cuban economy , for example Forex derivatives in the foreign exchange market (which is influenced by CADECA) or the protection of raw sugar in Central Camilo Cienfuegos with sugar derivatives. It is well known that the development of the Cuban economy makes the use of derivatives necessary, but not only for the defense of the underlying in hedging financial risk but also in the offense as a source of national income for Banco Nacional de Cuba .
Global applications by governments
Some governments limit their use of derivatives to improve the secondary market liquidity of their long-term bonds . Through this strategy, they obtain a liquidity premium that reduces the cost of interest. Other governments use derivatives for hedging and speculation. However, derivatives are also used completely illegitimately by some governments. These governments deliberately and systematically engage in transactions that do not have an economic justification, and that they themselves will condemn, and perhaps even prosecute, if they are discovered in the private sector.
Coverage
The volatility of coffee pricesexposes coffee producers to price risk. Price risk is one of the many risks faced by commodity producers. Coffee is widely traded on international derivatives commodity markets. This offers a margin for coffee producers to manage their price risk by hedging in these markets. A hedging mechanism is based on the use of coffee options and futures. The mechanism involves costs, so the benefits of coverage must be evaluated to assess its usefulness to producers. The main benefit is that producers can allocate resources more efficiently in coffee production. An analysis of the theoretical and field evidence can show that this benefit can be potentially very high, especially for risk-averse producers. This underscores the need to provide producers with access to adequate risk and price hedging mechanisms.
Speculation
Speculation is the purchase of a derivative instrument in the hope that it will become more valuable in the near future. In finance, speculation is also the practice of engaging in risky financial transactions in an attempt to profit from short-term fluctuations in the market value of a negotiable financial instrument, rather than trying to profit from the underlying embedded financial attributes on the instrument, such as capital gains, dividends, or interest.
Many speculators pay little attention to the fundamental value of a security and instead focus exclusively on price movements. In principle, speculation can involve any tradable good or financial instrument. Speculators are particularly common in the equity, bond, commodity futures, currency, artwork, collectibles, real estate and derivatives markets.
Speculators play one of the four main roles in financial markets, along with hedgers, who transact to offset other pre-existing risks, arbitrageurs seeking to profit from situations where expendable instruments are traded at different prices in different segments. market, and investors who seek profit through the long-term ownership of the underlying attributes of an instrument.
Lush and structured derivatives
A derivative product is a financial instrument created or whose value depends on (is derived from) the value of one or more underlying assets or asset value indices. Derivatives may include forwards, futures, options, swaps (currency and interest rate), caps, floors, collars, and rate locks.
Structured investments are financial instruments that are created (structured) through the grouping or redistribution of assets, transfer liabilities (backed by sets of assets) and / or separation of the credit risk of the guarantee assets of the originating entity. Examples of such instruments commonly used by government entities may include asset backed securities, mortgage backed securities, various secured obligations and credit derivatives, among others.
