Financial Dictionary - Derivatives
Financial derivatives or futures comprise an agreement whereby two investors commit to the purchase and sale of a security (an underlying asset) at a future date (maturity date). Specifically, during this negotiation, both parties agree on the price of the transaction as well as the maturity date and all the other conditions at the present time. The buyer is thus obliged to buy the underlying asset by paying the agreed price on the agreed date. And the seller will have to sell the asset for that amount on that date.
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Characteristics of financial derivatives
At the time of trading, it is not necessary to pay the value of the underlying asset, and it is sufficient to provide collateral (typically 10-20% of the price of what you trade). This is what is known as "leverage": increase the amount we invest over and above the amount we have available. Therefore, it must be said that these products have a high risk, and therefore you should be familiar with them before you invest in them.
Those that retail investors have access to are regulated, standardised contracts traded on official markets. There is a wide variety of regulated contracts, the most common being those on indices (IBEX, NASDAQ, etc.), bonds (German Bund or American T-Note, etc.), commodities (wheat, soya, coffee, etc.), energy (Brent oil, natural gas, etc.), metals (gold, silver, copper, etc.) or shares.
In reality, however, there are an infinite number of derivative contracts through which virtually any underlying asset can be traded. As it is a bilateral trade (buyer-seller), a derivative contract can be made "on anything", as long as there is a counterparty willing to take the opposite position. This is called an "OTC" or "over the counter" contract, which means that the two parties agree on what they are trading and the terms of the trade. This is the type of positions that institutional investors take. By way of example, there are contracts on rainfall or hours of sunshine (imagine a farm that wants to be sure of what it will receive for its harvest).
Uses and functions of financial derivatives
They can be used to provide coverage, by protecting us from the possible fluctuation of the price of the underlying asset.
Or as a means of speculation, as they can be bought and sold to take advantage of differences in the price of the underlying.
Lastly, they can serve as arbitrage, if we both buy and sell two correlated derivatives that have lost their correlation at a certain point in time, and expect them to regain their correlation.
How is it traded?
By entering into such a product, the investor can take a long or buy position, and make a profit when they go up; or a short or sell position, thereby gaining in value if the market goes down. In addition, Futures are standardised, and we can close our position without waiting for the maturity. To do so, we just have to carry out the opposite operation, i.e: sell if you are long, and buy if you are short.
In addition, if we close out our position before the expiry date, we will close out our position at the price of the future at the time of the trade, rather than at the price agreed at the outset.
Lastly, if we contract derivatives traded on regulated markets, they will settle gains and losses on a daily basis. This means that we do not have to wait for our position to expire or close before realising the gain or loss, but rather the result will be calculated daily and debited or credited to our account. (See example IBEX 35 Futures).
Therefore, when we trade a futures contract, we lock in the price at which we want to hold it in the future, and the result (gain or loss) will be the settlement or closing price of the position against the price at which we initially opened the position.
Lastly, it should be noted that when the maturity date arrives, we can "extend" our position to the next maturity, which is known in the market as "rolling" the position. This operation involves closing the position in the current maturity, and opening the same position in the next maturity, which will keep us exposed to the market, keeping our initial position open for a longer period of time.