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What Is Financial Derivative?

Financial derivatives or derivative instruments are defined as all financial products whose value is based on the price of another asset. In this case, the asset on which the derivative depends is called the underlying asset, for example, as in the case of the Future over gold, the underlying asset becomes logically gold (a commodity) since it is based on the Price of this. The main function of the derivatives market is to provide financial instruments for investment and hedging that allow adequate risk management. With the derivatives, the underlying assets can be of many types, among which we can mention the following:

  • Shares of the Stock Exchange.
  • Stock indexes.
  • Foreign exchange.
  • Raw materials (commodities).
  • Interest rates.
  • Fixed income securities.

The derivatives market can be divided into:

Stock Market: It is the market in which the operations are carried out in a recognized stock exchange. If you talk about Latin America for example, in Mexico, the Derivatives Exchange is known as the Mexican Derivatives Market (MexDer) which operates with Futures contracts and options on the dollar, the euro, stocks, bonds, interest rates and indexes. In the United States, a recognized exchange that works with derivatives is the Chicago Stock Exchange, which is the leader in the negotiation of futures contracts in the trade of agricultural goods.

Extrabursatil Market: This is the market where transactions are carried out directly between buyers and sellers without a central counterparty that serves to reduce credit risk.

Main features of financial derivatives

Financial derivatives have the following general characteristics that must be taken into account by every investor:

Derivatives require a very small initial investment and in some cases zero in comparison to other types of contracts that present a similar response to changes in general market conditions. This allows the investor to have higher profits as well as higher losses if the transaction does not develop as he believed.

The value of the derivatives changes in response to changes in the price of the underlying asset. Currently there are derivatives on all types of assets such as currencies, metals, agricultural products, livestock products, stocks, stock indices, etc.

Derivatives can be traded on organized markets such as stock exchanges or non-organized ones, or OTC.

Like all contracts, derivatives are settled at a future date.

Types of Financial Derivatives

Basically you can divide the financial derivatives that are currently traded in the following types:

1.) Derivatives according to the type of contract

This classification can be divided in turn into the following typology:

Options

Futures (either in Organized Markets or in OTC markets, where they are known as Forwards).

Contracts for Difference (CFD)

Swaps or exchanges (SWAPS)

2.) Derivatives according to the complexity of the contract

According to the degree of complexity of the contracts, the derivatives can be divided into the following types:

Exchange-Future-Conventional Option : Also known as “Plain Vanilla”.

Exchanging-Futuro-Exotic Option : This type includes “Bermuda” and “Asian” type options.

3.) Derivatives according to the place where the negotiation of the contract is carried out

Depending on the place where the contract is negotiated, these are usually divided into:

Organized Markets or MMOO: In this case the contracts are standardized which means that there will be only derivatives on underlying assets that the market has previously authorized. In addition, both the prices in exercise and the expiration of the contracts are the same for all participants. In the organized markets there is a greater transparency with respect to the prices.

OTC or “Over The Counter”: These are derivatives whose contracts (underlying assets, terms and others) are tailored to the parties that contract the derivative. With the OTC, there is no standardization in the Organized Markets, which means that both parties can set the conditions that most favor them.

4 ) Derivatives according to the underlying asset of the contract

Likewise the derivatives are usually classified with respect to the underlying asset that they use in the following types:

Financial Derivatives: These are the derivatives that use assets such as stocks, currencies, interest rates, credit risk and bonds.

Non-financial derivatives: Derivatives that fall into this category include those that use commodities as the underlying asset. Among the raw materials that are used in operations with derivatives we have food (cereals, citrus, soy, corn, etc.), metals, energy (oil, gas, electricity and others) and others.

Derivatives on assets of other types : Today, it is also traded with derivatives that use underlying assets of other types such as general indexes of prices, inflation and even climatic conditions.

5.) Derivatives according to the purpose of the contract

Finally we have derivatives that are classified according to their purpose. These are usually classified according to the following types:

Coverage derivatives: These derivatives are used as a tool to reduce risks. In this case the opposite position is taken in a futures market against the underlying asset of the derivative.

Arbitration Derivatives: Derivatives that seek to take advantage of the difference in prices between two or more markets. Through arbitration, market participants can achieve a virtually risk-free gain. With these derivatives, profits are achieved because of the difference in market prices.

Trading Derivatives: Derivatives that are traded in order to obtain gains from speculation on the price of the underlying asset.