With time and the emergence of new technology, trading in financial instruments have become more common and much more accessible to everyone and anyone who is interested in engaging in financial activities. For this reason, it is rightly so that information is delivered and made available to help interested parties to enter into the global financial markets with some level of confidence.
Financial derivatives, also known as common derivatives, have been in the markets for a long time, predominantly been used by large multinational companies to manage different types of risk. Over the years these type of financial instruments have also begun to play an important role in the everyday lives of ordinary people. Nowadays, online trading has made it easy to have access and trade in derivatives, although many may not yet be completely aware of this fact.
The derivatives market is an extremely large market with billions of derivatives been traded globally every year. The main reason why it is such a huge market is that derivatives are available and can be traded in various assets including bonds, stocks, commodities, currencies, etc. The global derivative market is in fact estimated to be roughly around $1.2 quadrillion in size, with the largest markets for derivatives trading in Asia Pacific and North America.
The derivatives market is divided into two categories, namely Over the counter derivatives and exchange-based derivatives. Over the counter derivatives are derivatives that are traded directly between the parties involved in the binding agreement, without the supervision of any exchange.
Exchange-based derivatives are derivatives that are traded on an exchange. Here the exchange serves as a counterparty between the two parties engaged in the agreement. The core function of the exchange is to ensure fair and orderly trading and the efficient circulation of information on prices of securities that are traded on that exchange.
The Chicago Mercantile Exchange is an example of an exchange where derivatives are traded. It is common for large institutional investors to use OTC derivatives and for smaller individual investors to use exchange-based derivatives for trades. This is due to the higher level of default risk associated with using OTC derivatives.
On the face of it, a Derivative is a financial instrument that “derives” its value from an underlying asset. A simpler definition is that a Derivative is a contract between two parties that specifies conditions which payments are to be made by both parties, where the worth and quality of the contract is based on an actual asset.
An example is a forward contract on gold, the forward contract is the derivative whilst the gold is the underlying asset. There are a number of underlying assets such as stocks, bonds, currencies, interest rate and all kinds of commodities that are used to create derivatives. The value of the derivative is highly influenced by the value and the change in the value of the underlying asset mentioned or agreed upon during the formation of the contract.
Types of Derivatives
There are a number of derivatives that are traded on an exchange or over-the-counter. The common derivatives that are traded online are:
A forward contract is a financial instrument that is set up as an informal but binding agreement between two parties which is completed with a buyer and a seller. This type of contract is traded through a broker if online and it’s either agreed upon on a one-on-one basis or transacted via an Over-The-Counter exchange.
Specific terms of the contract such as the value of the underlying asset, quality of the asset, the delivery date, the quantity of the asset and if applicable the place and mode of delivery the asset is agreed during the formation of the contract by both parties.
Futures derivative is a common derivative based on an agreement between two parties to buy or sell assets ranging from commodities such as sugar to shares which is paid for at a later date with a set price. This type of derivative is executed through an exchange which acts as a counterparty to both buyer and seller. The terms of the contract such as price, quantity, specifications, and delivery date are standardized per the exchange’s regulations.
This type of derivative gives the buyer of the “Option” the right but not the obligation to buy (Call option) or sell (Put option) a contracted quantity of the underlying asset, at a pre-determined price and on or before a specified date. This type of contract is bluntly one-sided and the buyer of the option is obliged to pay the seller of the option an amount upfront known as an Option premium.
A swap is an agreement between two parties to exchange cash flows or funds on specific dates, based on the terms of the contract. They are not traded on an exchange but rather a customized OTC between both parties.
Misconceptions about Derivatives
Financial Derivatives Causes Financial Markets to Crash
In the finance world, investments with higher risks potentially offer greater returns. One may end up being a millionaire by investing in a technology driven startup and one is more likely to lose all his or her investments by doing so. Derivatives in itself does not create risk, they transfer the risk to another.
During the aftermath of the 2008 financial crises, it was proposed by regulators that strong mechanisms were needed to be put in place to regulate all kinds of derivatives because it was believed derivatives caused the crisis.
Companies like AIG did do some derivatives and did suffer some huge losses as a result. But the actual cause of the crisis was as a result of a mortgage market meltdown. Rather than being tagged as the “cause” of financial destruction, derivatives if used properly can make our lives easier and its existence has helped solve real world issues that confronted businesses.
The Risks Associated with Financial Derivatives Are New and Unknown
The type of risks associated with derivatives is no different from those associated with other commonly known financial instruments. Though risks associated with derivatives can be far more complex, these common types of risks such as credit risk, operating risk, market risk and so on do exist. Risks associated with derivatives mostly originate from the customer of the derivative. For example, when a prospective homeowner borrows a sum of money, the type of mortgage he chooses poses a risk to the customer and the lending company.
Why Trade in Derivatives
They can be a Good Short Term Investment
If one is looking for an investment opportunity that pays off in the short term, derivatives may be a good option to look at. While some financial instruments such as stocks and bonds are long-term investments and can last over a period of many years, derivatives do and can bring in returns in days, weeks and in few months.
A good way to manage your portfolio as an investor is to have a portfolio consisting of a good mixture of short and long-term investments and derivatives can be a good option to make your money work for you now. Making derivatives work for you requires careful research and consideration just like any other investment opportunity.
Variety and Flexibility
The nature of derivatives essentially means that opportunities for trading in them are only limited by one’s imagination. Numerous resources are available on the Internet to help interested persons learn more about derivatives trading and many options are available for individuals to focus on. Those interested in derivatives training may want to begin by focusing on a particular area, such as currency trading.
Some types of trading options are available around the clock, on a global scale. This is another reason some investors are drawn to derivatives trading. Getting involved in the global economy can be exciting, and it opens international options that may not be available through the traditional stock market.
Even though derivatives trading present an excellent way of managing risk and breaking into the trading market, derivatives are rarely used in finance or transactions in Ghana. This is because they are not fully appreciated in the country’s financial market.
However on October 1, 2019 the Bank of Ghana started a forward sale purchase of forex in the country, this initiative might be what is needed to have a viable derivative market in Ghana. All in all, with some skill, research, and a bit of luck, derivatives can be a good way to earn some needed income.
The writer is a Financial Policy Analyst (GOY Business Channel)