Question

1. What are financial derivatives and what can they be used for?

2. What are some examples of financial derivatives?

3. In finance, what are options and some types of options?

4. What are forward contracts?

Answer 1

1. Financial Derivatives - Financial Derivative is an agreement between a buyer and seller and it specifies a future price at which the underlying asset (commodity, financial security) can be bought or sold on or before a future date.

They are known as derivatives because the price of a derivative is derived from the price of the underlier. Derivatives are used for to perform two main functions – Hedging and Speculation

Hedging – In Hedging, financial derivatives are used to reduce the financial risk and manage uncertainty

Speculation – Speculators use derivatives to profit from derivatives by speculating the future price of the underliers. It is somewhat like gambling.

2. Example - There are infinite examples of financial Derivatives but all of them fall under four main categories of Derivatives. They are – Forward Contracts, Futures, Swaps and Options.

3. Options –An option gives its holder the right but not the obligation to buy or sell the underlie at a future specified price on or before the expiry date. One simple example of an option is explained.

Example – Suppose an investor Andy believes that the stock of ABC company will increase over the next six months which is currently trading at $50. So, Andy buys an option on this stock at a strike price of $50. Suppose that after six months ABC Stock is trading at $55. Now, Andy can exercise this option and realize a net profit of $5. If suppose that after six months ABC company stock trades at $45. As option gives its holder the right but not the obligation to buy the underlier at a specified price (called strike price- which is $50 in this case) on or before a future date. As the price of ABC stock has decreased so Andy can choose not to exercise the option and buy the ABC stock at $50 (strike price).

4. Forward Contracts – Forward contract is an agreement between the buyer and the seller where the buyer agrees to buy the underlier (physical commodity or financial security) from the seller on a future date at a specified price. They are the simplest derivatives and traded in OTC market. Through a forward contract the parties of the contract are obligate to buy/ sell the underlying asset. It means that the buyer (long party) is obligated to buy the undelier and the seller (short party) is obligated to sell it.