Derivatives

Types of securities whose value is derived from other financial instruments and price movements. These kinds of derivatives are used as hedging instruments to avoid financial loss in the event of reversal movements in the market. Derivatives are often used with currency and interest rates to “Control Risk”.
A derivative is used by these investor types:

Hedgers:

Investors, traders, or commodity owners that attempt to minimize losses as a result of price fluctuations, by taking an opposite position in another market.  

Speculators:

Investors that make trading decisions associated with above average risks in an effort to generate abnormally high profits.  

Arbitragers:

Investors that look for price differences of the same financial security in different markets.  

A derivative include these instruments:

Forward Contracts:

Involves negotiations between two parties to buy an asset at a specific future date for a value amount that is agreed upon today.  

Future Contracts:

Standardized contracts that are traded on a regulated exchange, where the delivery of the agreed amount of a commodity, currency, or instrument is required by law.

Options:

A contract that specifies the quantity of a certain commodity with the specified date of the transaction.  Option buyers are not obligated to execute a sale, but sellers must abide by contract stipulations if the buyer chooses to execute the deal.

Types of Options:

Call option:

Gives the buyer the right to buy (but not the obligation) a specified amount of securities at a specific price and date.

Put option:

Gives the buyer the right to sell (but not the obligation) the option to the writer at a specific price and date.

Swaps:

Flexible, private, forward-based contracts or agreements thatare used to hedge against exchange risk from mismatched currencies on assets and liabilities.
 

Derivative Risk:

Basis risk:

 The price of a hedged asset subtracted from the price of the derivative contract.

Credit risk:

 The possibility of one party defaulting on their financial obligations under a derivative contract.

Market risk:

Financial loss due to changes in the value of a derivative, including different types of risks control, accounting and legal risks.