The concept of derivative financial instruments

The economy always links a huge number of markets: securities, labor, capital and many others. But all these elements are united by a multitude 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 fields. The world financial system, including the financial market and the money market, also does not dispense with them.

What is meant by a derivative?

In a general sense, a derivative is a category formed from a simpler quantity or form. In mathematics, the concept of derivatives reduces to finding a function as a result of differentiating the original function. Physics understands the derivative of the rate of change of a process. 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 a direct practical application in the financial market.

Derivative, or the concept of derivative instruments of the securities market

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 was closely located in the financial market and almost lost its original meaning. Today the notion of derivative securities is not unique, in the course of such definitions as: a secondary security, a derivative of the second order, a derivative, a financial derivative, etc., which in no way affects the general meaning.

A derivative, or second-order financial instrument, is a fixed-term contract that is concluded between two or more participants, formally through a stock exchange or an informal way, involving financial organizations, which is based on determining the future value of a real asset or higher-order instrument.

Key Characteristics of Derivatives

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

1. Derevativ is a contract in the success of which two or more persons or organizations are interested. Depending on how the market behaves and, first of all, the price, one side will be the winner, the other - in the loser. This process is inevitable.
2. A financial contract can be concluded through a stock exchange formalized or outside the exchange with the participation of enterprises and business associations on the one hand and banks and non-bank financial organizations on the other. The presence or absence of an exchange largely determines the specificity of the derivative.
3. The derivative of the second order in finance, like in mathematics, has a basis, or basis. Only if natural sciences reduce everything to the simplest functions, the financial market operates with real assets. On the exchange, the real assets are divided into four categories: goods or commodity assets (passed the test for exchange standards); Securities (stocks, bonds) and stock indices; Currency transactions and futures (specialized contracts).
4. The term of the contract depends on the type of financial instrument. Determining the exact date of the contract is designed to protect interests and reduce risks for both parties. But, as a rule, only one gets a prize from the transaction.

Derivative securities: concept, types, purposes of use

The specific feature of the exchange as a market segment is that it performs not only the function of "pricing" (it is inherent in most of the known markets today), but also risk insurance. For this, the parties agree to conclude a contract and determine the exact date of its implementation, reducing the risks of losses in the future.

Under the warranty conditions that ensure the implementation of fixed-term contracts, there are three main types:

• Futures.
• Forward.
• Optional.

Let us consider them in more detail.

Futures as a type of derivative financial instruments

Futures were pioneers on the stock exchange as financial instruments. And bushels of wheat and rice coupons guaranteed to agricultural producers a profit, regardless of whether the year turned out to be fruitful or not.

Futures contracts are the concept of derivative financial instruments associated with the conclusion of a futures exchange contract for the purchase and sale of the underlying asset, while the parties agree only on the level of fluctuation in the price of the asset and bear the obligations to the exchange until the "execution" deadline.

While the contract is operating, the price can fluctuate strongly depending on changes in the economy, politics, market conditions, natural factors, prices of related products. Buyers benefit when stock prices are lower than those for which a contract was awarded. And vice versa.

A significant disadvantage of the circulation of futures (primarily commodity futures) is that in the end they are divorced from real assets and do not reflect the real state of things in the economy. In the total cost of futures, one-fifth is the real value of the goods, and four-fifths is the price "for risk."

Forward, or "front" contract

Forward, along with other contracts enters into the notion of derivative instruments of the financial market, its informal part. In other words, forwards are rarely found on the stock exchange, but often are concluded directly between entrepreneurs of one or different spheres of economic activity.

Forward contract or forward (from English "forward") - an agreement between the parties on the delivery of goods in a strictly specified period. As can be seen from the definition, the forward most often operates with commodity assets, rather than securities or financial instruments. Another significant difference between the forward and other instruments is that it can be based on non-standardized goods and even services. Commodity commodities that have passed the strictest quality control and compliance with international standards are allowed on the exchange. For goods outside the exchange, this requirement does not apply. The responsibility for the product lies entirely with the supplier, and the risks with the buyer.

The agreed price of the forward is called the delivery price. During the term of the contract, it is unchanged. But as 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, sell and a deal with the premium.

Option contracts on the exchange

Crown derivative financial instruments, concepts, types and subspecies options contracts. Until 1973, they met only on commodity exchanges, but only eleven years later became the second-largest instruments on the world financial market.

Now at the heart of the option can be almost any asset: security, stock index, commodity, interest rate, transaction in currency and, more importantly another, another financial instrument. The option is a third-order derivative, a superstructure over another financial superstructure.

Proceeding from the foregoing, the option is a formalized and standardized exchange rate contract allowing one of the parties the right to fulfill or not fulfill obligations under the contract. Forwards and futures are mandatory for execution, the option is not. In other words, the buyer or seller must sell or buy the exchange asset before the contract expires, even if the transaction is unprofitable for them, and the owner of the option can avoid this fate.

Risk of Third-Order Derivatives in the Financial Market

In terms of risk insurance, the option is the most effective financial instrument. On the other hand, the existence 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 pumped up the market with unsecured money, and the slightest hint of instability grows into the scale of the global financial crisis. For an unstable world economy, which has been exposed to natural, economic and political shocks in recent years, this is more than enough. The new global financial crisis is just around the corner.