Financial derivative products could protect our investment from unfavorable events. The profit comes with risk, so the investment also contains several risks. If we invest in foreign currency, we are afraid of the appreciation of the home currency. Similarly, investors in the stock market will not expect the decline of purchased stocks price in the future. Financial derivative products are instruments whose values or prices depend on their underlying instruments, such as commodities, interest rates, indices or stocks. Let us say that an option contract has a value of 0.05 USD for a 10.00 USD single stock. The price may go up to 0.07 USD as the stock price falls to 9.00 USD, or an inverse scenario might happen.
Where can we buy financial derivative products?
There are two types of markets for derivatives. Firstly, Over-The-Counter (OTC) market provides a bilateral contract between the seller and buyer of a derivative instrument. This market occurs where buyer and seller directly transact without third parties. Simply, OTC is the trading of securities between two parties outside of formal exchanges and without the oversight of exchange supervision. As opposed to trading on a centralized exchange, OTC refers to how the securities are traded through dealer networks ( a decentralized site that has no physical location).
However, the OTC market has some shortfalls. Default risk may occur when there is no delivery of the subject matter of the contract. Multiple coincidences come up where counterparties should transact in the same need. Poor price discovery or price squeeze might happen.
Secondly, the exchange trade serves standardized financial derivative products. The regulated market eliminates all OTC market’s shortages. In addition, the exchange regulation guarantees the default risk. The trading mechanism discovers proper pricing for each derivative product. Many joining market participants erode multiple coincidence needs.
Common Financial Derivative Products
1) Currency Forward Contract
A forward contract is an agreement between two parties to conduct a transaction at a future date but at a price set today. A producer who promises to furnish the product (underlying asset) and a consumer who needs the product later could be the two parties. Practically, exporters and importers use this contract to hedge foreign currency risk. Using this product, counterparties exposed to bid-ask spread similar to spot foreign exchange transactions. Therefore, this product is a costly method to hedge the risk to some extent. This financial derivative product is available only in the OTC market.
2) Currency Futures Contract
A futures contract is essentially a forward contract that has been standardized in terms of contract size, maturity, product quality, delivery location, and other factors. This product is available within an exchange trade. There will be no bid-ask spread in this contract, reducing transaction costs. Chicago Mercantile Exchange and Country Futures are good examples of how this product works in more detail.
3) Stock or Currency Option Contract
An option is a financial instrument that allows the holder the right, but not the obligation, to sell (put) or buy (call) another financial instrument at a predetermined price and expiration date. If the buyer requests it, the put or call option seller must fulfill the contract. Because the option to not buy or sell has value, and the buyer of the option must pay a premium to the seller of the option for this right.
There are two styles of options. A European option can only be exercised at maturity, whereas an American option can be exercised at any time up until the expiration date. An option contract is an exchange-traded derivative product. You can find how the product works in our particular article about options here. An excellent example of financial option exchange could be New York Stock Exchange (NYSE).
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