What are financial derivatives?

2023-06-19
Summary:

Financial derivatives can be used for risk management, speculation, and arbitrage purposes. Common financial derivatives include futures, options, swaps, and swaps.

The concept of financial derivatives

Financial derivatives, also known as financial derivative instruments, refer to derivative financial products that are based on the underlying product or variable and whose price depends on changes in the price (or numerical value) of the underlying product. As a relative concept, basic products not only include spot financial products (such as stocks, bonds, certificates of deposit, currencies, etc.), but also financial derivatives. The basic variables of financial derivatives are diverse, mainly including interest rates, exchange rates, inflation rates, price indices, various asset prices, and credit ratings. Financial derivatives are formally represented as a series of contracts that specify the type of transaction, price, quantity, delivery time, and location.

Financial Derivatives Currency

Classification of financial derivatives:

1. According to the different types of financial derivatives contracts, the most common financial derivatives in the current market are financial forwards, financial futures, financial options, financial swaps, etc.


2. According to the classification of underlying assets, they can be divided into stock (stock futures, stock options), interest rate (interest rate forward, interest rate futures, interest rate options, interest rate swaps, bond futures, bond options, etc.), currency, and commodity categories;


3. According to the classification of trading locations, it can be divided into over-the-counter trading (exchange trading) and over-the-counter trading (OTC market trading);


4. According to the classification of independence, it can be divided into independent derivative products and embedded derivative products.


Basic characteristics of financial derivatives:

① Intertemporal. Financial derivatives are contracts in which both trading parties predict the trend of changes in factors such as interest rates, exchange rates, and stock prices and agree to trade or choose whether to trade at a certain time in the future based on certain conditions. Financial derivatives will affect the cash flow of traders in the future or at a certain point in time, reflecting the characteristics of cross-period trading.


② Leverage. Financial derivative transactions generally only require a small amount of margin or premium to sign large forward contracts or swap different financial instruments. At the same time, the risks and losses borne by traders will also be multiplied, and slight changes in basic tools may bring significant gains and losses to traders.


③ Linkage. The value of financial derivatives is closely related to the underlying products or variables. The payment characteristics typically associated with financial derivatives and underlying variables are specified by derivative instrument contracts, and their linkage can be expressed as either a simple linear relationship or a nonlinear or piecewise function.


④High risk. The consequences of financial derivative trading depend on the accuracy of traders' predictions and judgments on the future prices of underlying instruments. The unpredictable prices of basic tools determine the instability of gains and losses in financial derivative trading.

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