A derivative is a contract signed between two parties on an asset whose value is underlying subject to the fluctuations in the market. Derivatives are influenced by the market price and some perfect examples include bonds and stocks which are sold when the prices increases. Other assets include interest rates and currencies among others whose prices in the market cannot be defined (Investopedia, 2010).
Types of derivatives
There are a number of derivatives and they include; forward contracts, future contracts, spot contracts, call options, hedges, interest rates swaps, currency swaps, and credit swaps.
Forward contracts are those agreements that are signed by two parties looking at transacting business in the future, and can be used in circumstances that involve financial transactions which can be used as debt instruments. These instruments are referred to as interest-rate forward contracts, which are sold at a point in the future. Interest rate forward contracts specify the date of delivery of the debt instrument, its interest rate, which in this case is their cost, as well as the actual debt that is awaiting delivery in the future. The pros that come with forward contracts are that they are flexible in that the parties can make as many changes to the operational plan as possible and this way, both parties are able to hedge the risk of loosing money. The cons of forward contract are that the parties may suffer losses by selling the instruments at a lower price as they maybe unable to find a counterparty who is interested in such a deal. The other disadvantage of forward contracts is the inability to liquidate, as they may not have the required money to pay off the debt incurred by the interest. Forward contracts do not come with guarantees and this makes them risky to the parties involved (Derivative markets, 2010).
A future contract is a legal agreement between two parties that is entered to when it comes to transactions which will happen in the future, and at a predetermined price which is here referred to as the future price. The pros that accompany this contract are that business is possible with a small capital, which acts as a deposit. It helps traders to predetermine prices for their commodities way in advance which is healthy for business as they can tell if they will make profits or loses.
This enables the traders to steer clear from possible fluctuations, which would affect their businesses negatively (RMA, 2007). The cons that come with future contracts are that traders are at a risk of loosing their investment if they are not conversant with how the system works and the fluctuations experienced in the prices can effect negatively on them. Lack of basic but important knowledge in future contracts is detrimental to business. The best way to succeed in future contracts is to start with popular contracts, which amounts into a perfect strategy to gain an edge in this market (Heitkoetter, 2010).
Spot contracts are mostly used with foreign currencies and they are the best due to their convenience. They deal with currency conversions in the least time possible and this makes it the best mode of currency transfer internationally. The pros of this contract are that they mostly happen electronically (International Banking group, 2010) and they bring about healthy competition and at the same time present the flexibility necessary for this trade. They also give parties a choice which allows them to settle for what appeals to them the most. Spot contracts are also low in risk and cater to the needs of an individual. However, the stability of spot contracts is questionable as they keep fluctuating. It is also hard to monitor as its market is flooded which has brought about high competition. Their lack of potential economies for the purchasers also comes in as a limitation to this contract (Stephens, 2010).
This is an agreement between two parties where the investor has the right to buy an asset or instrument at a given price known as a “strike price” in a prescribed period referred to as an “expiration date”. Call here is used to represent the act of buying that particular asset. The characteristic feature about call options is that going up of the asset prices promises the investor profits (Investopedia, 2010). The pros of this trade include flexibility, which allows the investor to employ various strategies to ensure that they make profits amidst the fluctuation in the market. Call options also offers the investor leverage without necessarily subscribing to it.
The risks involved in his form of trade are limited and this makes it conducive for investors and through hedging, investors are able to evade fluctuations and thus do not risk their investment. However, call options running costs are higher and this does not reflect well on the profits to be gained and also Liquidity happens to be low and this may make it impossible for investors to pay their loans. To add on, the options that this trade offers are complex and this limits the trade to those who are not well conversant with it. Call options come with an expiry trade, which means that if this date is reached before a sale is made then the investor incurs, loses (Wreford, 2009).
A hedge is a form of an investment that is made with the intention to cushion it from fluctuations through compensation using another instrument. The pros experienced with hedges include diversification where the investor is able to direct the funds elsewhere to avert the market’s weaknesses. They reduce the investment risks by cushioning the investor through short selling. The flexibility that characterizes hedges makes it easy for investors to come up with new strategies to ensure that they are making profits despite the market weaknesses.
Hedges allow the investors more options and this enables them to make more money. However, hedges can be expensive to run, as they demand high fees to be able to perform. They also operate discreetly in the market and this may make it hard for other investors to access their information. They are limited to qualified accredited investors and this does not favor the public. The strategies used with hedges are also complex and this makes them inaccessible to many investors (Articlesbase, 2008).
Interest rates swaps
This is an agreement between counterparties where they resolve to exchange future interest’s payments for another’s future cash flow. They are used by investors to manage the risks as well as hedge to ensure that they get the most out of the market. The advantages linked to interest swap rates include high liquidity, which is conducive for trade. The fact that they are privately placed makes them less liable to risks as they cannot be accessed by the public. They are long term and can be in trade for up to 10 years and they are also strong against the market weaknesses. They are highly flexible and this allows for customization. Interest rate swaps come with their limitations, which include counterparty risks, which are broken down as credit, and interest rate risk. Either party stands to loose money according to the market prices (Daigler & Steelman, 1988).
A currency swap is whereby parties enter an agreement where a second currency is used in the repayment of interest and principal to the other party and vise versa. Their advantages include flexibility, which allows for exploitation of other currencies and maturities. They also provide exposure since they offer grounds for exchange and re-exchange. The pricing is right and withstands the market weaknesses better as compared to other contracts. (Sooran, 2010)
This is the credit transfer of fixed income from one party to another whereby the seller gives a guarantee on the product. The buyer in turn gets credit protection from the seller and in this way; the liability is taken off the shoulders of the buyer to the sellers. The advantages of credit swap include diversification thereby allowing buyers to initiate many strategies to gain an edge in the market. This way they are able to delegate this trade to others who are more qualified. Its shortcomings include that it can amount to poor management due to its complexity and this may lead to low liquidity and inefficiency.
The various different types of derivatives covered in this case study pose their advantages and disadvantages to the market; and how well they are managed depends on how well people understand their operations. They can be a profitable tool or a business disaster and that is why people must be well versed with their operations.
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