The economy always connects a huge number of markets: securities, labor, capital and many others. But all these elements are united by a variety of financial instruments that serve a variety of purposes.
The concept of derivative financial instruments
The economy is replete with terms related to the functioning of various systems, industries, market elements. The concept of derivatives is widely used in many scientific fields: physics, mathematics, medicine, statistics, economics and other fields. The global financial system, including the financial market and the money market, cannot do without them.
What is meant by a derivative?
In a general sense, a derivative refers to a category formed from a simpler quantity or form. In mathematics, the concept of derivatives is reduced to finding a function as a result of differentiation of the original function. Physics understands by derivative the rate of change of a process. The concept of derivative financial instruments and the functions that they perform are closely related to the nature of the derivative as a whole and have direct practical application in the financial market.
Derivative, or the concept of derivatives of the securities market
The word "derivative" (of German origin) originally served to denote the mathematical function of a derivative, but by the middle of the 20th century it had closely settled in the financial market and almost lost its original meaning. Today, the concept of derivative securities is not one of a kind, in the course of such definitions as: a secondary security, a second-order derivative, derivative, financial derivative, etc., which does not affect the general meaning.
A derivative or a financial instrument of the 2nd order is a fixed-term contract that is concluded between two or more participants, formally through an exchange or informally with the participation of financial organizations, based on which the future value of a real asset or instrument of higher order is determined.
Key characteristics of derivatives
This definition has several key components from which the concept and types of derivative securities come from:
- Derevativ is a contract in the success of which two or more persons or organizations are interested. Depending on how the market behaves and, above all, the price, one side will benefit, the other will lose. This process is inevitable.
- A financial contract can be concluded through a formalized exchange or off-exchange with the participation of enterprises and business associations on the one hand, and banks and non-bank financial organizations on the other. The presence or absence of the exchange largely determines the specifics of the derivative.
- The second-order derivative in finance, as in mathematics, has a base, or basis. Only if the natural sciences reduce everything to the simplest functions does the financial market operate with real assets. On the exchange, real assets are divided into four categories: goods or commodity assets (tested for exchange standards); securities (stocks, bonds) and stock indices; currency transactions and futures (specialized contracts).
- Contract term - depends on the type of financial instrument. Determining the exact date for executing the contract is designed to protect interests and reduce risks for both parties. But, as a rule, only one gain comes from a deal.
Derivative securities: concept, types, purposes of use
A specific feature of the exchange as a market segment is that it performs not only the function of “pricing” (it is inherent in most markets known today), but also risk insurance. For this, the parties agree to conclude a contract and determine the exact date of its execution, reducing the risks of incurring losses in the future.
Under warranty conditions that ensure the execution of fixed-term contracts, there are three main types:
- Futures.
- Forward.
- Optional.
Let's consider them in more detail.
Futures as a type of derivative financial instruments
Futures were pioneers on the stock exchange as financial instruments. A bushel of wheat and rice coupons guaranteed agricultural producers profit, regardless of whether the year was fruitful or not.
Futures contracts - the concept of derivative financial instruments associated with the conclusion of a fixed-term exchange contract for the sale and purchase of the underlying asset, while the parties agree only on the level of fluctuation in the price of the asset and bear obligations to the stock exchange until the maturity date.
As long as the contract is in effect, the price can fluctuate greatly depending on changes in the economy, politics, market conditions, natural factors, prices for related products. Buyers win when exchange prices are lower than those for which the contract was concluded. And vice versa.
A significant minus of the circulation of futures (primarily commodity) is that in the end they are divorced from real assets and do not reflect the real state of things in the economy. In the final cost of the futures, one fifth is the real value of the goods, and four fifths is the price “for risk”.
Forward, or “front” contract
Forward, along with other contracts, is included in the concept of derivatives of the financial market, its informal part. In other words, forwards are rarely found on the stock exchange, but often are concluded directly between entrepreneurs of one or different areas of economic activity.
Forward contract or forward (from the English "front") - an agreement between the parties on the delivery of goods within a strictly agreed period. As can be seen from the definition, the forward most often operates with commodity assets, rather than securities or financial instruments. Another significant difference between the forward and other instruments is that it can be for non-standard goods and even services. Commodities that have passed the most stringent quality and international standards testing are allowed on the exchange. For goods outside the exchange, this requirement does not apply. Responsibility for the product lies entirely with the supplier, and the risk lies with the buyer.
The agreed forward price is called the delivery price. During the term of the contract, it is unchanged. But since this creates certain difficulties for the parties, the exchange offers its alternative forward contracts, which are otherwise called, but, in essence, the same as forwards: an exchange transaction with a pledge to buy, to sell and a deal with a premium.
Options contracts on the exchange
Crowned by derivative financial instruments, the concept, types and subspecies of option contracts. Until 1973, they were found only on commodity exchanges, but after only eleven years they became the second most widely traded instruments on the world financial market.
Now, an option can be based on almost any asset: a security, stock index, commodity, interest rate, currency transaction and, more importantly, another financial instrument. An option is a third-order derivative, an add-on over another financial add-on.
Based on the foregoing, an option is a formalized and standardized exchange futures contract that allows one of the parties the right to fulfill or not fulfill obligations under the contract. Forwards and futures are required, the option is not. In other words, the buyer or seller must sell or buy an exchange asset by the time the contract expires, even if the transaction is unprofitable for them, and the option holder can avoid this fate.
Risk of the presence of third order derivatives in the financial market
From the point of view of risk insurance, an option is the most effective financial instrument. On the other hand, the availability of options and options on options contributes to the separation of the financial market from the real commodity market more than any other financial instruments. Options pump the market with unsecured money, and the slightest hint of instability is expanding into the scale of the global financial crisis. For an unstable world economy, which in recent years has been subject to natural, economic and political shocks, this is more than enough. Not far off is the new global financial crisis.