The concept of derivative financial instruments

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Economy always connects a huge number of markets: securities, labor, capital and many others. But all these elements are combined 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 certain systems, industries, market elements. The concept of derivatives is widely used in many scientific fields: physics, mathematics, medicine, statistics, economics and other areas. The world financial system, including the financial market and the money market, cannot do without them.

What is meant by derivative?

In a general sense, a derivative is a category formed from a simpler value 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 the rate of change of a process as a derivative. The concept of derivative financial instruments and the functions 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 securities market derivatives

The word "derivative" (of German origin) originally served to denote the mathematical function of the derivative, but by the middle of the twentieth century it had become firmly established in the financial market and almost lost its original meaning. Today, the concept of derivative securities is not the only one of its kind, such definitions as: secondary security, second-order derivative, derivative, financial derivative, etc. are in use, which in no way affects the general meaning.

A derivative, or financial instrument of the 2nd order, is a futures contract that is concluded between two or more participants, formally through an exchange or informally with the participation of financial institutions, based on the determination of the future value of a real asset or an instrument of a higher order.

Key characteristics of derivatives

This definition has several key components from which the concept and types of derivative securities come:

1. A derivative is a contract in which two or more persons or organizations are interested in its success. Depending on how the market behaves and, above all, the price, one side will win, the other will lose. This process is inevitable.
2. Financial contract can be formalized through the stock exchange or outside the stock exchange with the participation of enterprises and associations of enterprises on the one hand and banks and non-banking financial institutions - on the other. The presence or absence of an exchange is largelydefines the specifics of the derivative.
3. 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: commodities or commodity assets (which have been tested against exchange standards); securities (stocks, bonds) and stock indices; currency transactions and futures (specialized contracts).
4. Term of the contract - depends on the type of financial instrument. Determining the exact date for the execution of the contract is designed to protect the interests and reduce risks for both parties. But, as a rule, only one person wins from the 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. To do this, the parties agree to conclude a contract and determine the exact date of its implementation, reducing the risk of incurring losses in the future.

There are three main types of guarantee conditions that ensure the performance of fixed-term contracts:

• Futures.
• Forward.
• Optional.

Let's take a closer look at them.

Futures as a variety of financial derivatives

Futures were pioneers on the exchange asfinancial instruments. And bushels of wheat and rice coupons guaranteed farmers a profit, whether it was a good year or not.

Future contracts are the concept of derivative financial instruments associated with the conclusion of a fixed-term exchange contract for the purchase and sale of the underlying asset, while the parties agree only on the level of fluctuations in the price of the asset and are liable to the exchange until the “fulfillment” deadline.

While 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 benefit when stock prices are lower than those at which the contract was made. And vice versa.

A significant disadvantage of the circulation of futures (primarily commodities) is that in the end they are divorced from real assets and do not reflect the real state of affairs in the economy. One-fifth of the total futures price is the real value of the goods, and four-fifths is the risk price.

Forward or forward contract

Forward, along with other contracts, is included in the concept of financial market derivatives, its informal part. In other words, forwards rarely occur on the stock exchange, but are often concluded directly between entrepreneurs in the same or different areas of economic activity.

Forward contract or forward (from the English. "Forward") - an agreement between the parties on the delivery of goods within a strictly specified period. As can be seen from the definition, the forward most often operates with commodity assets, and not with securities or financial instruments. Another significant difference between a forward and other instruments is that it can be for non-standardized goods and even services. Commodities that have passed the strictest quality control and compliance with international standards are admitted to the exchange. This requirement does not apply to OTC goods. The responsibility for the goods lies entirely with the supplier, and the risks are 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 fact, the same as forwards: an exchange transaction with a pledge to buy, to sell and a transaction with a premium.

Option contracts on the stock exchange

Crowning derivative financial instruments, the concept, types and subspecies of option contracts. Until 1973, they met only on commodity exchanges, but after only eleven years they became the second most traded instruments on the global financial market.

Now an option can be based on almost any asset: a security, a stock index, a commodity, an interest rate, a currency transaction and, more importantly, another financial instrument. An option is a third-order derivative, a superstructure on another financial superstructure.

Based on the foregoing, an option is a formalized and standardized exchange term contract that allows one of the parties the right to fulfill or not fulfill obligations under the contract. Forwards and futures are binding, options are not. In other words, by the time the contract expires, the buyer or seller will have to sell or buy the exchange asset, even if the deal is unprofitable for them, and the option owner 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 presence 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 fiat money, and the slightest hint of instability escalates into a global financial crisis. For a volatile global economy that has been subject to natural, economic and political shocks in recent years, this is more than enough. A new global financial crisis is just around the corner.