DERIVATIVE

A derivative is a financial product whose value is based in the price of an asset. The asset upon which the derivative depends on is known as an underlying asset. These assets are financial assets such as shares, interest rates, etc.

The main types of underlying assets are:

  1. Rate interests
  2. Stocks
  3. Bonds
  4. Credit risk
  5. Currencies

These derivatives have the following characteristics:

  1. Its value is modified according to the changes in the underlying asset’s price
  2. The initial investment that must be made is much less when buying the underlying asset directly.
  3. They are always settled in a future date.
  4. They are normally listed in stock markets.

The most commonly negotiated derivatives are swaps, futures and options.

  • Futures: are contracts that entail the purchase or sale of good or services (underlying asset) on a certain and future date, with its price and quantity being settled beforehand. You don´t have to pay up-front, but you do have to give a guarantee of the payment.
  • Options: are contracts that gives the right (not the obligation) to buy or sale a good or service (underlying asset) at a predetermined price, until a certain date (due date). When contracting an option, you must pay a small fee, and normally provide a guarantee, too. If it is a buy option it is called “call option”, and if it is a sale option it is called “put option”.
  • Swaps: are contracts for which two parties promise to exchange future goods or services.

The purchase of these financial products is to:

  • Assure the future price of the underlying assets in a way that these financial products play the role to help control the volatility of the underlying asset.
  • Speculate with these derivatives, with the goal of gaining an economic profit. This commercialization of purchase-sale rights has extended vastly over the past few years, making them one of the most demanded financial products in the market.
  • Gain arbitrage for which you obtain a certain «risk free» profit.