Understanding derivatives in financial management
A derivative is a financial instrument which is derived from another underlying financial instrument and then traded as a product in its own right. Its value is determined by fluctuations in the price of the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Using derivatives in financial market risk management can greatly reduce your exposure but only if you know exactly what you are doing. Understanding the financial derivative instrument is extremely difficult. Many finance students are somewhat lost when studying derivatives. Our finance homework service has helped numerous students with derivative assignments and if you have problems we can assist you as well.
Using derivatives in financial management may be done for a number of different reasons including:
- Insuring against price movements (hedging) on an asset
- Increasing exposure to price movements for speculation or
- Gaining access to otherwise hard-to-trade assets or markets
Types of derivatives in financial management
A derivative is a category of security rather than a specific kind and because of this there are several different kinds of derivatives that have different functions and applications. The following are financial derivative examples of some of the different types:
- Futures contracts: Futures are one of the most common types of derivatives. A futures contract is an agreement between two parties for the sale of an asset at an agreed upon price. They are often used to hedge against risk during a particular period of time.
- Swaps: A swap is a common type of derivative that is usually a contract between two parties agreeing to trade loan terms. You might use an interest rate swap in order to switch from a variable interest rate loan to a fixed interest rate loan in order to secure more financing. Swaps can be made using interest rates, currencies or commodities.
- Credit derivative: This type of derivative is a loan sold to a speculator at a discount to its true value. By selling the loan at a reduced rate the lender will regain most of the capital from the loan. That money can then be used to issue a new loan that is more profitable
- Options: Options are an agreement between two parties giving one the opportunity to buy or sell a security from or to the other party at a predetermined date in the future. The buyer or seller is not obligated to make the transaction if they decide not to thus the name “option.”
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