Financial Derivatives

Financial derivatives are contracts whose value is derived from the performance of underlying Assets, indices, or Interest Rates. They are used for various purposes, including Hedging risks, speculating on future price movements, and Arbitrage.

Common types of financial derivatives include:

• Options: Contracts that give the holder the right, but not the obligation, to buy or sell an underlying Asset at a predetermined price before a specific date. For example, a call option on Stock allows the holder to purchase the Stock at the Strike Price.
• Futures: Agreements to buy or sell an Asset at a future date at a predetermined price. For instance, a futures contract on crude oil obligates the buyer to purchase a specified amount of oil at a set price on a future date.
• Swaps: Contracts in which two parties exchange Cash Flows based on different financial instruments. An example is an Interest Rate swap, where one party exchanges a fixed Interest Rate payment for a variable rate payment from another party.
• Forwards: Customized contracts to buy or sell an Asset at a specified future date for a price agreed upon today. For example, a Forward Contract to purchase currency at a future date at a fixed rate.

Cases in which financial derivatives are commonly used include:

• Hedging: Companies may use derivatives to protect against adverse price movements, such as a farmer using futures contracts to lock in the price of crops.
• Speculation: Investors might buy Options or futures to profit from expected price changes, such as a trader buying call Options on a Stock anticipated to rise.
• Arbitrage: Traders exploit price discrepancies between markets, such as buying a Stock in one market and selling it in another through derivatives.