How do derivatives work?
Derivatives are financial instruments that derive their value from other more fundamental variables, such as the price movements stocks, bonds, or commodities; interest rates changes; and even the prices of other derivatives. The most common classes of derivative securities are futures, forwards, swaps, and options. Futures and forwards are contracts whereby two parties (say a large group of farmers and Unilever or Kellogg’s) agree to a future trade at a specific time and price. Common types of futures include oil, cattle, and U.S. Treasury bond futures. The main difference between forwards and futures is that futures trade in the open market (like stocks or bonds) whereas forwards are private contracts.
Swaps are similar to futures and forwards, but the agreements are for multiple trades in the future. For example, an insurance company might agree to pay the interest on a floating rate security it owns to a hedge fund that agrees to pay a fixed rate in return. This sort of agreement would be struck because the cash flows better match the two parties’ risk profile and funding needs.
Options are contracts where two parties agree to a possible trade in the future (“possible” because one party has the right but not the obligation to complete the trade). If the buyer has the right, this is a “call.” If the seller has the right, it is a “put.”
Derivatives are used for three main purposes. Despite attention-grabbing headlines that suggest they are always exotic, volatile, and potentially very lucrative financial instruments, they are mainly used to hedge or provide financial insurance.
Arbitrageurs also use them, seeking to exploit differences in prices for identical instruments in different markets in an attempt to earn a riskless profit. Finally, speculators looking to make spectacular profits use derivatives. In a corporate finance role, you will mainly have to construct, pitch, and/or evaluate simple as well as extremely complex derivative instruments for hedging and financial insurance.
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