Home Derivatives

Derivatives

Types of Derivatives In A Glance

Types of Derivatives In A Glance

Derivative securities play an essential role in the stock market, and are often cited as impacting the current economic crisis. There are two primary types of stock derivatives that an investor may choose to purchase: exchange traded derivatives and over the counter (OTC) derivatives. There are benefits and disadvantages associated with each of these types of securities.
Exchange traded derivatives are derivatives traded on an organized, regulated exchange. Essentially, over the counter derivatives function in the same manner as exchange traded derivatives, only they are dealt between individual parties as part of private arrangements. In many cases, exchange traded derivatives will require a greater deal of collateral than over the counter derivatives.
Therefore, an investor may find it beneficial to purchase an OTC derivative as opposed to an exchange traded derivative. Besides, purchasing a derivative often provides a stockholder with the security of obtaining a specified number of shares for a set price. Therefore, if the price of stocks increases, an individual that purchased a derivative security will be permitted to obtain stocks at a lower price.
However, it is important for an investor to understand some of the problems that are often associated with these types of securities. An investor must be cautious when purchasing derivative securities, especially if they are seeking to attain over the counter derivatives, as some issuers try to take advantage of the inexperience of new investors. Therefore, an investor may pay more than necessary for a derivative security.

Derivatives Explained

Derivatives Explained

Investing in shares of a company’s stock can be quite complicated. In particular, one of most confusing aspects of stock exchange for beginning investors to grasp is the concept of derivatives, as few financial experts stop to provide an understandable description of how derivatives function.
A derivative is a type of security whose value is based upon the value of another stock or asset. When an individual or a company wishes to protect its investments, it may choose to purchase a derivative. Derivatives may be paid for by individuals who have made, or wish to make, a large financial investment in a company. More commonly, a derivative will be purchased by a small business, and in some cases, a large corporation.
In most cases, when an individual or a business purchases a derivative, they are gaining the issuing company’s permission to purchase 100 shares of stock for a specified price by a designated day. Therefore, if the value of stocks begins to fluctuate, the derivative holder will be permitted to purchase a large quantity of shares for the agreed upon price. This may benefit an investor if stock values increase. However, if stock prices decrease, derivatives may cause an investor to lose financial resources.
Such is the case with futures contracts. If stock prices have decreased when the contract expires, an investor will still be required to purchase the shares for the strike price. If this agreed-upon price is more than the current price of the shares, the investor will lose money.
An individual or a corporation may choose to purchase exchange traded derivatives, or over the counter derivatives. There are various differences between these two types of derivatives. It is common for investors to seek derivatives from organized exchanges, and for businesses to purchase derivatives over the counter. 

Facts About Exchange Traded Derivatives

Facts About Exchange Traded Derivatives

Like with stocks, there are two very different markets for the trade of derivatives. An investor may seek to obtain exchange traded derivatives or over the counter derivatives. Exchange traded derivatives are financial securities that are traded at an exchange, such as the New York Stock Exchange.
At an organized exchange, derivatives that are exchange traded are governed by a set of rules and regulations. On the other hand, over the counter derivatives are often left unmonitored, and inexperienced individuals that purchase these types of securities may end up losing funds to issuers.
There are many potential benefits associated with exchange traded derivatives, as an exchange makes it easy to keep track of this type of derivative and knows who maintains financial obligations to whom and who can help guarantee that neither investors nor corporations disregard their financial responsibilities.
Futures contracts are very important types of exchange traded derivatives, especially for investors who purchase a large quantity of stocks. Often, the concept of futures is difficult to understand and it, therefore, helps to explain exchange traded futures in simple terms.
For instance, a popular and growing bakery company will need to purchase an extensive quantity of sugar in order to continue baking desserts and operating productively. However, like all commodities, the price of sugar constantly rises and falls. If one year from now, the price of sugar has increased sufficiently, the baking company will be required to spend more money than typical on this baking necessity. 
If the value of sugar falls, then the sugar cane producer selling this commodity to the bakery will not make the profit that he/she anticipates. In order to protect both parties, they may choose to enter into an exchange traded futures contract. Both the producer and the buyer will agree on an acceptable price for a specified quantity of sugar and on a designated date the bakery will be required to purchase the sugar from the producer for the agreed upon price.
Exchange traded futures contracts function in a similar manner for stock shares. Two entities, often a company and an investor, will develop a legal agreement governing the sale and purchase of a designated quantity of stock shares for a specified price on a certain future date. These types of exchange traded derivatives help to protect both corporations and investors from substantial market fluctuation.
Options are another important type of exchange traded derivative. Just as their name implies, options contracts provide investors with the choice to purchase a share of stocks for a specified amount of money. For example, if an investor wishes to purchase a share of stocks four months from now, but he/she fears that the price of the stocks will increase by then, he/she can seek to obtain an exchange traded options contract. 
The issuing corporation and the investor will develop a contract specifying the quantity of stock that he/she will obtain, the cost of the stock, and the date in which the investor must purchase the stock. The investor will generally be required to provide the company with a deposit for the option. 
When the option’s date of expiration arrives, the investor will decide whether he/she wants to purchase the stocks at the agreed upon price. If the price of the stock has dropped, the investor will not be obligated to adhere to the option, and he/she may choose to purchase the stock for the lower price.

Read This Before You Do Over the Counter Exchange

Read This Before You Do Over the Counter Exchange

Financial derivatives provide investors with a way to secure investments. They may be traded in an organized exchange or over the counter. Unlike exchange traded derivatives, over the counter, or OTC, derivatives are not carefully monitored or regulated.
Over the counter financial derivatives are private agreements that usually occur between two companies or between a company and an investor. In most cases, the companies involved in issuing OTC derivatives are commercial banks, investment companies, and hedge funds.
There are numerous complications and problems associated with OTC derivatives. While all of the aspects of exchange traded financial derivatives are carefully detailed, many aspects of OTC derivatives are left unaddressed or unspecified. For example, it is common for the duration of over the counter financial derivatives to be flexible. Another potential problem associated with these securities is that companies often require investors to offer collateral in order to obtain OTC derivatives.
Therefore, if the investor defaults on the agreement, the issuing company may seize the personal property that was offered. However, the companies issuing the financial derivatives will not need to offer collateral, and therefore, there is little to stop them from defaulting on an agreement.
Because an exchange does not monitor or regulate OTC derivatives, there is often little that can be done to compensate investors if a company defaults on an agreement. Many within the United States Congress favor the use of exchange traded derivatives, and wish to have OTC derivatives discontinued. If this occurred, an organized exchange would have the ability to better track all derivatives in order to ensure that no party involved in a contract is defaulting on an agreement.
However, banks and corporations do not wish to do away with OTC derivative contracts. In most cases, the business of selling derivatives allows a bank to make a substantial profit. Non-financial institutions also do not want OTC derivatives to be discontinued, as they are much less expensive to obtain because exchange traded derivatives require large quantities of collateral.
There are many different types of derivatives sold over the counter. Options, swaps, and forward contracts are all forms of OTC derivatives. They each work in a similar manner to their exchange traded derivative counterpart. For example, forward contracts function much like futures contracts, allowing both a buyer and an issuer to agree upon a specified price, which an investor will be granted to obtain a designated share of stocks on a certain date in the future. However, instead of being regulated by an exchange, this derivative is sold over the counter. This allows a derivative to be modified so that it suits the needs of the investor.

Usage Derivatives Overview

Usage Derivatives Overview

Just as there are stock markets designated for the trading of stocks, there is also a derivative market for derivative trading. There are two primary reasons why an investor would take part in derivative trading. An investor generally purchases derivatives because he/she is either speculating about the future of the economy, or he/she is attempting to protect his/her investments. In many cases, investors will participate in the derivative market in order to protect their investments.
One of the primary purposes of derivative trading is to assist in hedging risk. When an investor takes part in hedging risk, he/she will purchase a derivative from the derivative market in order to decrease the threat posed by negative price fluctuation. Price fluctuation can cause an investor to turn a profit, but just the same, in many cases it results in substantial financial losses. In order to protect themselves against financial ups-and-downs, a business will often sell futures contracts.
Futures contracts, which are common in derivative trading, are often utilized in hedging practices. A company will sell futures contracts to investors in the derivative market. These contracts will detail very specific information about the terms and conditions of the financial agreement between a corporation and an investor.
For example, a futures contract will outline the shares of stock that an investor will be required to purchase and the established price of the stock. The contract will also specify the date on which the contract expires. Therefore, an investor must purchase or sell these instruments by the designated date.
Derivative trading may help to protect corporations and investors against stock value fluctuation.  For example, if an investor purchases a futures contract from the derivative market, he/she will obtain a set cost for a specified quantity of stocks. If stock values have increased by the date that he/she is required to purchase the shares, then the issuer will be obligated to adhere to the contract, granting the investor stocks for less than they are currently worth.
If the value of the stocks decreases, then the company will make a profit off of the futures contract, because, unless he/she purchased an option, the investor will be required to pay the strike price for the stocks.
Investors may also choose to partake in the derivative market as a means of speculation. It is a common practice for individuals to attempt to predict the condition of the market. They may try to determine when the value of shares will increase and when they will decrease. If an individual suspects that the stock market will fluctuate, he/she may attempt to take advantage of this through derivative trading.
For example, if an investor believes that stock values will increase, he/she may purchase a futures contract. Therefore, if the price for shares of stock does increase, he/she will be able to obtain the stock at a lower price than its current value, and in turn make a profit. However, this is a risky undertaking. If the price of stocks decreases, the investor will end up losing money on his/her investment.