Methodology

Investing Basics

Module 2

What is a portfolio?

Understanding Derivatives

The term ‘derivative’ refers to a type of financial contract, which changes in value depending on the value of an underlying asset (i.e. a stock or commodity), group of assets (i.e. a group of stocks), or index (i.e. S&P 500). The contract involves two or more parties (buyers and sellers) and can be traded on the market.

 

Derivatives can also be traded over the counter, with individuals being able to purchase certain types through their bank. Derivatives are commonly used by investors to access certain markets or to hedge against certain risks. The most common underlying assets are stocks, bonds, commodities, currencies, interest rates and indices.

 

Traders use derivatives to hedge against risks, speculate in financial markets, or increase holdings. Derivatives can be used to reduce risk, although they typically increase the cost of investing as they are expensive to use.

Advantages of Derivatives

Derivatives provide businesses and investors with a number of potential advantages. These include being able to lock in prices in a contract, hedge against certain risks, and access limited markets.

 

An investor may purchase a derivative contract that moves in the opposite direction to the value of an asset that they already own, to offset potential losses in that asset – thus minimising risk.

 

Accessing limited markets is beneficial as the investor can take advantage of certain opportunities i.e. an investor could access lower interest rates in a country that would otherwise be off-limits to them.

 

Specifically using a derivative called an option, investors can speculate on the future value of an asset, without committing to buying or selling it. Although options can be expensive, the potential returns can be significant.

Disadvantages of Derivatives

Despite the advantages of derivatives, there are significant drawbacks. Derivatives infamously played a significant role in the global financial crisis of 2007 to 2008. A key problem with derivatives is that they are hard to value. This is because most derivatives are sensitive to the time to expiry of the contract, interest rates, and the cost of holding the underlying asset.

 

As derivatives have no intrinsic value, they are vulnerable to market risk. It is possible for the supply and demand of derivatives to rise and fall, regardless of what is happening with the underlying asset.

 

Derivatives are difficult to understand, which means that it is easy for inexperienced to make mistakes when using them. They are also expensive and increase the cost of investing for an investor.

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