Financial Derivatives

There are a lot of financial derivatives which exist and this article is going to list some important and popular ones . Keep in mind, these financial derivatives can be very complex and NO ONE understands it all.

Financial Derivatives are instruments that are made from other substances and their value is also based on something else (known as an underlying asset). These derivatives are brought into existence when two or more parties create a contract, where the value is determined by fluctuations in a underlying asset.

What makes these derivatives so dangerous to the extent where Warren Buffett called them “weapons of financial destruction”, is because when you price a derivative, there an assumption that the financial markets are frictionless (this is a false and stupid assumption). The derivatives market is worth roughly $600 trillion. This is over 10 times more than the total value of the entire World.

Derivatives aren’t all bad and scary, they are very useful for farmers to leverage against a bad crop season. Also, a company can use it as a form of insurance for raw materials. Derivatives are seen as dangerous because they’re mostly being used by hedge funds and other investors to gain more leverage increasing the risks of a complete market collapse.

1. Equity Derivatives —> A derivative whose underlying assets are based on equity securities (a.k.a. stocks).
   1. Examples:
      1. Equity Options
      2. Equity Index Options
      3. Equity Index Futures
         
2. Interest Rate Derivatives —> A derivative whose underlying assets are based on an interest rate. It’s mainly used to speculate on whether interest rates will rise or fall.
   1. Examples
      1. Bond Futures
      2. Interest Rate Futures
3. Foreign Exchange Derivatives —> A financial instrument which locks in a future foreign exchange rate. It’s mainly used by currency trades.
4. Credit Derivatives —> Used by firms to elevate credit risk on loans. Collateralized debt obligations are an example of these type of derivatives. They’re tremendously risky and it is a Major Cause of the Great Recession in 2008.
   1. Examples
      1. Credit Default Swaps
      2. Collateralized Debt Obligations

There are many risks to derivatives however the biggest risk is that it’s nearly impossible to know the true value of a derivative. Another one is that people leverage them tremendously. On some types of derivative trading, traders are only required to put up 2%-10% of the contract into a margin account to purchase derivatives.

In conclusion: Firms need to ensure that Financial Derivatives are used properly by measuring the risks they hold. Most importantly, regulators need to monitor financial firms with large derivative positions very carefully.