Financial derivatives are investment products whose value is derived from an underlying asset or set of assets. Derivatives are used by investors to manage risk, speculate on the price movements of underlying assets, and gain exposure to different markets. In this article, we will discuss five different types of financial derivatives and their uses.
Futures Contracts
Futures contracts are agreements between two parties to buy or sell an underlying asset at a specified price and date in the future. Futures contracts are traded on exchanges and are used by investors to speculate on price movements or to hedge against price changes. For example, a farmer may use futures contracts to lock in a price for their crop before it is harvested.
Options Contracts
Options contracts are similar to futures contracts, but they give the holder the right (but not the obligation) to buy or sell an underlying asset at a specified price and date. Options can be used by investors to speculate on price movements or to hedge against price changes. For example, an investor may purchase a call option on a stock if they believe the stock price will rise in the future.
Swaps
Swaps are agreements between two parties to exchange cash flows based on different variables, such as interest rates or currencies. Swaps are used by investors to manage risk or to gain exposure to different markets. For example, a company that has a variable-rate loan may use an interest rate swap to convert the loan to a fixed-rate loan.
Collateralized Debt Obligations (CDOs)
CDOs are securities that are backed by a pool of debt obligations, such as mortgages or credit card debt. CDOs are used by investors to gain exposure to a diversified pool of debt obligations. For example, an investor may purchase a CDO that is backed by a pool of mortgages.
Credit Default Swaps (CDS)
CDS are contracts between two parties where one party agrees to pay the other party if a credit event occurs, such as a default on a bond or loan. CDS are used by investors to manage credit risk or to speculate on the creditworthiness of a company or country. For example, an investor may purchase a CDS on a company's bond if they believe there is a risk of default.
In conclusion, financial derivatives are complex investment products that are used by investors to manage risk, speculate on price movements, and gain exposure to different markets. The five types of financial derivatives we discussed in this article are futures contracts, options contracts, swaps, collateralized debt obligations, and credit default swaps. It's important for investors to understand the risks and benefits of these products before investing. Consult with a financial advisor before making any investment decisions.