Derivative and Its Four Types

Running Head: DERIVATIVE 1
Derivative and Its Four Types
Student’s Name
Institutional Affiliation

Derivative and Its Four Types 2
Abstract
Derivative performance depends on the performance of the underlying asset. Alternatively, there
are four primary types of derivatives; options, swaps, forwards, and futures. Futures contract
provide a definite value certainty on both investors, which minimizes the risks connected with
the volatility price. In spite of this fact, speculators do not prioritize on owning the underlying
product. Instead, they enter the market to make a profit from the falling and rising in prices. The
contract limits the risk exposure, which an investor trades with. Contrary, the forward contracts
are agreements to sell or buy a property at a fixed date and value. Thus, financial institutions
need to adopt approaches that minimize the risks, and reduces the impacts of severe market
movements; the management is possible through hedging. Conversely, option contracts are
derivative of financial securities, which depend on the value of the asset, which allow the
investor to put the odds in their favor. Therefore, the options contract permits a firm the rights,
but not the obligation to sell or buy an underlying asset at a stipulated price before or on a
specific date. Moreover, a swap contract is an agreement between various parties that specifies
the swap terms that may include the legs underlying value, times, and payment frequency.
Hence, the majority of people enter swaps either to hedge against others positions or to predict
the future price of the underlying currency of a free leg. Consequently, Derivatives act as
financial agreements whose returns are connected to the underlying asset performance such as
commodities, bonds, and bonds. Derivatives have a significant impact on the financial systems
through risk management, price discovery, and efficiency of transactions

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Table of Contents
Introduction...........................................................................5
Financial Firms Utilize Certain Types of Derivatives...........................5
Futures Contracts.....................................................................5-7
Forward Contracts...................................................................7-11
Options Contracts...................................................................11-14
Swap Contracts......................................................................14-15
Numerical Examples on How Each Derivative Works.........................15
Futures Contracts....................................................................15-19
Forward Contracts..................................................................19-20
Options Contracts...................................................................20-21
Swap Contracts......................................................................22-23
Merits and Demerits................................................................23
Futures Contracts...................................................................23
Forward Contracts..................................................................23
Options Contracts...................................................................23-24
Swap Contracts......................................................................24
Implications of Derivatives........................................................24-26

Derivative and Its Four Types 4
Conclusion........................................................................26-27
References........................................................................28-31

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Derivative and Its Four Types
The derivative is an agreement between two parties that derives its value from an
underlying asset. Thus, it is a financial instrument for managing associated risks. Alternatively,
there are four common types of derivatives; options, swaps, forwards, and futures. Moreover, the
underlying corpus created can comprise of one financial security or a combination of several
financial securities. Hence, the underlying asset value is bound to shift as the assets keep
changing continuously. Generally, the underlying asset form depending on the currency, bonds,
stocks, interest, and commodities rates. Therefore, derivative performance depends on the
performance of the underlying asset. Hence, the asset trades in the market where the purchaser
and the seller mutually decide its value, then the seller gives the underlying to the purchaser and
is paid in return. Importantly, cash or spot value is the underlying price if bought immediately.
Analysis
Financial Firms Utilize Certain Types of Derivatives
Most of the retail banking attract deposits and loans. Thus, the difference between
interest rates on loans and deposits creates a profit. As such, the banks play various roles in the
derivatives market. Therefore, banks act as intermediaries in the OTC “over the counter” market,
matching purchaser and sellers, and earning commission fees (Future, n.d). Contrary, financial
institutions participate directly in the derivatives market as purchasers and sellers; they are
derivatives end users.
Futures Contracts

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Manufactures, importers, and farmers can be termed as hedgers. As such, the hedger sells
or buys in the futures market in securing the commodity’s future price intended to be sold later in
a cash market. Hence, it would assist protect against value risks, and considered an insurance
policy of sorts. Importantly, if someone spends a long time in a futures contract, then the
individual should secure the possible low price. Furthermore, if MNCs short-selling contracts,
then the firms want a high value as possible. Unfortunately, futures contract provide a definite
value certainty on both parties, which minimizes the risks connected with the volatility price.
Using futures contract, hedging can be utilized to lock in an acceptable value margin between
raw material cost, and the retail cost of the final commodity sold.
For instance, when one considers a corn futures contract that represents 5,000 bushels of
corn. This means the corn is trading at five dollars per bushel; the contract price is 25,000
dollars. As such, futures contracts standardize on the particular quality, and amount of the
underlying product (Investopedia, 2018). Therefore, the futures value moves about the spot value
for the product based on the demand and supply.
Market participants may not aim to reduce risks, but instead, benefit from the risky nature
of the future market. These are termed as speculators, which intend to participants intend to
profit from the value changes that hedgers cover themselves against (Investopedia, 2018).
Importantly, while hedgers prioritize on minimizing their risks on their investments, speculators
want to maximize their risk. Thus, maximizing potential profits (Investopedia, n.d). Hence,
speculators do not prioritize on owning the underlying product; rather, they enter the market to
make a profit from the falling and rising in prices.

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Table 1: This illustrates the differences between speculators and hedgers
Alternatively, in fast-paced markets into which data is continuously fed, hedgers and speculators
mutually benefit from each other. Thus, when the future contact is almost to expire, the better the
information entering the market will be about the specific product. Therefore, the market
participants can expect a more accurate reflection of the demand and supply, and a
corresponding value closer to the expiry date.
Uses of Futures Contracts.
Beers (2018) suggests that futures contracts limit the risk exposure, which an investor
trades with. Therefore, the agreement removes uncertainty regarding the future value of a
commodity. Thus, locking a price for which a firm will sell or buy a particular item, companies
can eliminate the barriers affecting the expected profits and expenses.
Forward Contracts
Juliao (n.d) asserts that the forward contracts focus on MNCs in the foreign exchange
markets. Thus, a firm may engage in business with various partners, who each utilizes its capital,
which means that the company receives payments in several currencies and have to exchange
them back into dollars or any other required currency. The daily fluctuations in the price of these

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currencies influence the firm’s revenues and costs. Therefore, the company is at risk of losing
funds because of the severe fluctuations. It is essential that MNCs plan their profits and expenses
depending on the market exchange. Conversely, the foreign exchange market comprises of
multiple worldwide transactions utilized by investors for buying foreign currency to selling
domestic currency. Thus, each currency contains its absolute price compared to another, which
determines the exchange rate.
The primary risk of the market is the progressive fluctuations of the exchange rates,
which can bring higher profits or cause severe losses. Importantly, a financial firm needs to
adopt approaches that minimize the risks, and reduces the impacts of severe market movements;
the management is possible through hedging. It may involve using various financial instruments
that increase the protection of investors against fluctuations in the exchange rate of currency
(Juliao, n.d).
Figure 1: Illustrates the change of the US dollar with other currencies from 1968 to 2003