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Derivatives changed the world of investing and finance trading. They are incredibly complex and require intricate knowledge of the investment market. Proper use of derivatives can provide dramatic rewards and risks. Usually, companies and individuals use them to hedge risk and improve returns. But what does this mean? By breaking down exactly what derivatives are and their uses, you may discover a new way of participating in the financial markets.

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What is a Derivative?

Originally, a derivative was a way to ensure exchange rates stayed balanced for internationally traded goods. Now, they are used for many other financial trades and can be incredibly complicated. A derivative is a category of financial security that receives its value from an underlying asset. This means that the derivative is more of a promise between parties based upon that asset. The asset’s price also determines the derivative’s price, and there are many different types of derivatives. These categories often share many similarities but carry a variety of benefits and risks. Understanding the trading of different derivative types will clarify the differences between them.

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Trading Derivatives

There are two ways to trade derivatives. The first is through an official exchange such as the New York or Toronto Stock Exchange. The second method is known as “over-the-counter.” This is when the security or derivative is traded somewhere other than a formal exchange. These over-the-counter trades often occur through a dealer network. Because these have fewer regulations and restrictions than the formal exchanges, they are open to more individuals while simultaneously carrying more risk.

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Futures Contracts

This type of contract is a promise to purchase an asset. For example, if you had shares of a company’s stock, and you’re concerned about their value dropping, you would likely want to sell them. A person may offer you a futures contract. Rather than buying your shares that day, they will promise to purchase them at a determined point in the future at the same price that they would have today. This is a kind of bet. You’re gambling that the shares will be worth less and you’ll make more money than if you were to wait a year to sell. Your futures contract partner is betting that they’ll be worth more, essentially saving him or her money.

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Forward Contract

Forward contracts are very similar to futures contracts, but there is a key difference. This type of derivative is only traded using the over-the-counter method. Because of this, forward contracts can also be customized to fit any commodity, amount, or delivery date. Their flexibility appeals to many different types of people and businesses.

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Options

Similar to a futures contract, options involve an agreement to buy or sell an asset at a future date. The primary difference is that options are, as the name implies, optional. If the date is reached and the buyer no longer wishes to purchase the asset, they are not obligated to.

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Credit Derivative

This type of loan is sold to someone at a portion of its total value. The seller can then use the capital they receive to finance another loan immediately. This allows banks and loan companies to ensure that they have the money in hand to finance the loans that benefit them the most. The loan purchaser receives a portfolio on the loan they purchase, allowing them to make informed decisions for the future of the loan.

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Swaps

One of the more complicated types of derivatives, swaps involve an agreement between parties to trade loans with each other. If a person has a variable interest rate loan and would rather have a fixed interest rate loan, they may approach their loan provider and request a change. Unfortunately, their loan provider has the option of declining the request. The loan holder can then suggest a loan swap with a person who has a fixed interest rate loan. Each party involved pays toward the other party’s loans at a rate both groups agree on, but the loans remain in their original holders’ names.

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Mortgage-Backed Security

This is a very broad and intricate category of loan that involves a security backed by a mortgage or series of mortgages. The bank acts as a middleman between the purchaser of the building and the participants in the investment market. The participants essentially act as lenders to the purchaser. The buyer makes their mortgage payments through the bank, which then sends predetermined amounts back to the investors. There are two types of mortgage-backed security: pass-throughs and collateralized mortgage obligations. Pass-throughs act as a trust, passing the mortgage payments onto investors. Collateralized mortgage obligations are made up of several pools of securities known as “tranches,” and receive credit ratings. The lower the credit rating, the higher the interest rate. This usually means the possible return for the investor is higher, but so is the risk.

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The Benefits of Derivatives

Each type of derivative has a set of limitations, options, and benefits.

  • Futures contracts allow participants to make more money with less risk. Increased market knowledge allows for safer involvement in futures contracts.
  • Forward contracts have many of the benefits of future contracts, while also allowing added flexibility and customization.
  • Options are an incredibly safe choice for purchasers. Since they’re not locked into the purchase, it’s a relatively risk-free way to increase earnings.
  • Credit derivatives allow the loan seller to immediately receive capital and move onto other loans and financial plans. There are modest returns in exchange for the lower risk.
  • Swaps provide a significant amount of flexibility for both loan holders.
  • Mortgage-backed securities allow for significant returns over a period of smaller, frequent returns.
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The Risks of Derivatives

As with all types of investing, there can be significant risks when dealing with derivatives.

  • If you bet wrong on a futures contract, you could potentially purchase an asset for more than its actual worth.
  • Forward contracts carry the same risks as futures contracts, but with the added risk of trade with untrustworthy parties.
  • Options are very low-risk, but if you are the seller, you could end up with a loss if your buyer backs out.
  • Credit derivatives may result in heavy losses if you purchase the loan of an individual who cannot reliably make payments.
  • Swaps rely heavily on both parties. Because the loans are still in the original names, one party failing to make payments affects the other party significantly.
  • Mortgage-backed securities were heavily involved with the U.S. housing market crash in 2007. They require expert knowledge and carry heavy potential losses.
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Disclaimer

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