What are financial derivatives

Derivatives: Five Important Questions About Forward Trading

Annette de los Santos, 11/11/2020

A large number of financial instruments are hidden behind the term derivatives, and new ones are constantly being developed. In the past, derivatives were mainly used by financial institutions and institutional investors validation other investments. They are now being advertised as a lucrative investment for private investors. Critics, on the other hand, describe derivatives as pure betting transactions.

The following article gives an overview of the most important to shape and your Risks.

What are derivatives and how do they work?

Derivative literally means “derived” (Latin “derivare”) and is a generic term for a large number of innovative financial products. They are also called Futures or Futures contracts designated.

What they all have in common is that they are basically one indirect investment e.g. in securities such as stocks or bonds, but also in commodities, currencies, indices or interest rates. Shares, for example, are not bought directly, but derivatives or futures transactions are concluded on the underlying "shares" and thus speculated on their future performance. Derivatives make it possible, even without real ownership of the underlying, to participate in its market development.

In contrast to an investment in the underlying asset, a derivative can also be used falling courses or prices be set. Derivatives on one rising price or value are called long, call or bull, those on one falling price or value as short, put or bear.

When buying derivatives, a reciprocal contract is concluded between seller and buyer, which can be very different depending on the product. For example, derivatives do not have to participate 1: 1 in the underlying, but other subscription ratios can also be set. As a result, there can be fluctuations in the underlying asset disproportionately depict.

The Terms of the individual investment products fluctuate depending on their design. The structure of a derivative can be very simple (e.g. knockout certificates) or very complex (contracts for difference or CFDs). The fee structure is often difficult to see and understand for the buyer. The same applies to the contractual conditions. (Inexperienced) investors can get into nasty surprises if they don't understand the terms and conditions.

Why invest in derivatives?

But it is not only because of their complexity that derivatives are a concealment high risks and are an investment for risk-taking investors.

Derivatives can be used by investors for the Total loss mean. This is particularly devastating for leveraged derivatives, where investors borrow money to invest. Because in the event of a loss, not only is the invested money gone, the investor also has to raise additional funds afterwards (Obligation to make additional payments).

Note: Only invest in derivatives if you are sure that you have correctly understood the complex products and terms of your investment. Calculate the total loss and invest capital that you can do without.

Nevertheless, derivatives are common financial products. Why do investors invest in futures contracts despite the high risks?

Hedging through derivatives

Institutional investors and financial institutions, as well as trading and industrial companies, use derivatives to transfer risks or to hedge transactions with underlying assets that are in their portfolio.

This process is called Hedging and has a long tradition, as derivatives trading is already several thousand years old. Originally, it mainly served to hedge against price fluctuations on commodity futures purchases in the form of simple futures.

Speculation with Derivatives

As early as the 17th century, transactions with derivatives in the form of options on rice without a physical delivery obligation were concluded for the first time in Japan. Also in the 17th century, the first speculative bubble arose in Amsterdam through derivatives in the form of forwards and options on tulips, which became known as "tulip mania".

Short-term speculation still attracts to this day, because the disproportionate risks of derivatives are often offset by above-average chances of profit. Just Derivatives with great levers are particularly attractive for speculators, because here you can go through the Use of little capital realize high profits.

In the meantime, diverse forms have emerged and derivatives trading is probably the fastest expanding and changing area of ​​international finance on the stock exchanges. In addition, the issuing financial institutions use individual names for the same product. There are even funds specializing in derivatives, e.g. gold investments in connection with futures contracts on gold.

What types of derivatives are there?

There are a large number of different derivatives and new, innovative products are constantly being added. Various categories of futures contracts are presented below.

Underlyings for derivatives

First, different derivatives can be categorized based on the underlying used. The following are common:

  • Securities (e.g. stocks, bonds)
  • Raw materials (e.g. gold, oil)
  • Foreign exchange (e.g. euro, dollar)
  • Merchandise or products of any kind
  • Key figures (e.g. indices, credit ratings)
  • Interest or interest rates or dividends
  • Second degree derivatives

Unconditional and conditional futures

In the case of conditional derivatives, there is an obligation to execute the forward transaction. These include Fixed business (e.g. futures or reverse convertibles) that have a fixed maturity date. Also futures that are listed as Swaps designed (e.g. cap, floor or collar) are conditional derivatives. Several fixed transactions in succession are agreed here.

In contrast to fixed transactions, the execution of the forward transaction is only an option with unconditional derivatives, which is why it is Option transactions (e.g. warrants). In return for an option premium, the right can be acquired to purchase a fixed amount of the underlying asset at a fixed price at a specific point in time (European option) or during a predefined period of time (American option).

Derivatives with leverage

Financial derivatives are often equipped with a leverage to the base value, which varies depending on the price development of the base value.

Example: derivatives with leverage
If you take a leverage of four with a subscription ratio of 1.0, this means that if the market price for the underlying asset (e.g. gold) changes by one monetary unit (e.g. US $), the derivative changes four times, both positively and positively negative. With a lower amount of money compared to buying the underlying, a significantly higher price gain can be realized if the price of the underlying is positive.

These investment products with leverage effect include "Naked" warrantswhich, in contrast to traditional warrants, do not certify the right to acquire shares in connection with a bond with warrants. An example of this are Knockout certificatesthat expire worthless when a certain threshold is reached. Mini futures guarantee a fixed residual value in this case. However, this is paid for in advance due to the higher acquisition costs. The respective designation of the same or very similar products varies depending on the issuer.

Common derivatives

CertificatesThis is a comparatively young product. Nevertheless, there are now a number of different types of certificates, some of which vary greatly in terms of their specific design. examples are Index certificates, Discount certificates or Reverse Convertible Bonds.

In principle, the rising, sideways trending or falling development of any underlying is always shown for all certificate types.

Futures (German future)Exchange-traded, standardized futures contracts in which a buyer and a seller agree in advance to trade any underlying asset on fixed terms.
ForwardsThese are futures traded over the counter.
ForexForex trading describes professional foreign exchange trading in which derivatives and leverage are used in order to be able to optimally exploit even marginal price fluctuations.
Leverage products“Leverage product” is a generic term for financial products that use leverage. A lever enables the disproportionate mapping of the base value and thus the profit or loss of the investment to be multiplied. Leverage products are for example Warrants, Knockout certificates, Mini futures and Binary options.
CFDsAlso called contracts for difference. This is an instrument of the Day trading, because they are for the short term Trade provided. They are not dissimilar to futures, as there is one here too Margin of a few percent is to be deposited as a security deposit and Obligations to make additional payments exist in the event of losses.

Contracts for difference can be used to bet on falling and rising prices. As with other derivatives, stocks, commodities, currencies and indices can be traded.

SwapsIn swap transactions, two market partners exchange future payment flows. There are often currency and interest rate swaps. In order to minimize the risk of changes in interest rates with the classic interest rate swap, limits (cap, floor and collar) are set.
FRAAlso at Forward Rate Agreements (FRA) and Forward Deposits it concerns interest rate futures, which, however, take place over the counter.

Where are derivatives traded?

Derivatives are traded both on the stock exchange and over the counter as OTC derivatives ("over the counter").

The world's largest derivatives exchanges for traders include Eurex (Germany / Switzerland), CME (Chicago Mercantile Exchange, USA) and the associated CBOT (Chicago Board of Trade, USA), KRX (Korea Exchange) and NYSE Liffe (Great Britain).

What costs should you consider?

Depending on the derivative, different costs are incurred, which are often not completely transparent for the investor. This applies, for example, to the elimination of dividend entitlements for share certificates or the Overnight interest of contracts for difference.

The derivative construct as such also plays a role if, for example, participation in the loss takes place in full, but in the profit only up to a certain amount. With mini futures, the residual value can be covered in advance via increased acquisition costs.

Banks and brokers who issue derivatives usually hedge them so that profits and losses are balanced out. They make their real profit with the fees and the so-called Spread, i.e. the difference between the buying and selling price. Although one can benefit from the infinite varieties (this is to be understood literally) of derivative financial instruments, it can be assumed that the principle applies here as well: "The bank always wins".

Invest in derivatives

Derivatives are undoubtedly one of the most speculative financial products. Due to the much lower capital investment compared to the underlying, they appear particularly tempting to investors. Another great advantage of derivatives over direct investment in an underlying asset is that they can be used to bet on falling markets.

The attractive performance of derivatives are, however, considerable, often too difficult to calculate risks across from.

If you have a lot of money, you can speculate.

If you have little money, you shouldn't speculate.

If you have no money, you have to speculate.

Stock exchange guru André Kostolany

For the reasons mentioned, we recommend investors stick to Kostolany and not speculate. In times of low or negative interest rates, it is undoubtedly difficult to achieve a return above the inflation rate at all, but investors should always carefully weigh the possible risks of a financial instrument.

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