What Are Financial Derivatives?

What Are Financial Derivatives?

Hi my name is patrick boyle welcome to my youtube channel this is the first video in a new series on financial derivatives where i aim to take you from the beginner level to the expert level over a series of videos in today’s video we’re going to learn what are financial derivatives who trades them and why so let’s get started what is a financial derivative

A financial derivative is an economic contract whose value depends on or is derived from the value of another instrument or underlying so a derivative is not a security like a stock or a bond where you have ownership in a company or have lent money to a company a derivative is simply a side bet with another party on how a different security will perform these

Derivatives are not issued by companies the way stocks and bonds are they don’t raise money for companies the way an ipo or a bond offering does they’re quite simply a side bet on how another financial product will perform and they derived their price from that financial product which we refer to as the underlying derivatives are often broken down or categorized

By the relationship between the underlying asset and the derivative so we’ve got things like forwards options or swaps they can also be broken down by the type of underlying asset so things like equity derivatives foreign exchange derivatives interest rate derivatives commodity derivatives are credit derivatives and finally they’re broken down by the market in

Which they trade so we’ve got exchange-traded derivatives and over-the-counter derivatives derivatives can be used for the purpose of speculation or for hedging a speculator is a trader who’s taking position with the goal of making a profit a hedge er is a trader who already has an economic exposure and who takes an offsetting position in order to reduce a risk

That they already have exposure to often people are a little bit confused by the term hedging they think it relates to the idea of a hedge fund which they often hear about in the press a hedge er is not a hedge fund it’s simply a person who is trading a financial instrument in order to reduce their risks are to hedge their risk they usually are already exposed to


A financial risk and their trading activity reduces that risk exposure there are a number of underlines for derivatives available right now and new ones are being developed all the time some of the most popular underlyings are equities which are also known as stocks which are listed on public exchanges companies like general electric citigroup our vodafone for

Example then we have fixed income derivatives things like government bonds corporate bonds credit spreads baskets of mortgages things like that and then we also things like commodities like gold silver cotton electricity then we also have indices and foreign exchange which are popular underlyings for derivatives there are even derivatives that pay off on things

Like weather events so our next thing we want to talk about is who trades derivatives with lots of people trade derivatives we often break derivatives traders down into different groups like hedgers and speculators hedgers are often producers or consumers of an underlying or companies that are required to typically have exposure to a particular underlying in

The normal running of their business derivatives allow the risk related to the price of the underlying asset to be transferred from one party to another so for example a corn farmer on the breakfast cereal manufacturing company like kellogg’s could enter into a futures contract to exchange a specified amount of cash for a specified amount of corn at some point

In the future in doing so both parties will have reduced a future risk and thus would be considered hedgers both parties reduce their exposure to certain variations in the price of corn which could materially affect their respective businesses essentially what we’ve got in that case it’s really just that they fixed a price in advance for a trade that they’ll be

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Doing at some point in the future in our next group speculators are individuals who seek exposure to risky assets with the aim of making a profit they’re often things like pension plan managers insurance companies are asset management firms financial speculation can involve trading by the i mean buying holding are selling and short selling stocks bonds commodities

Currencies real estate derivatives are any valuable asset to attempt to profit from fluctuations in its price irrespective of its underlying value many try to differentiate the concept of speculation from investing but for our purposes a speculator and an investor are the same thing they’re individuals or companies who take a derivatives position with the goal of

Profiting from it rather than with the goal of reducing their risk or hedging their exposure our next group we’re going to talk about our arbitrage earth so arbitrage is the practice of taking advantage of a price difference between two or more markets it usually involves the simultaneous purchase and sale of an asset the profit being the difference between the

Market prices arbitrage is a trade that profits by exploiting price differences of identical or extremely similar financial instruments on different markets or in different forms our patrasche exists as a result of market inefficiencies it provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time when the

Term arbitrage is used by academics an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and the positive cash flow in at least one state so in simple terms what that means is that it’s the possibility of a risk-free profit at zero costs we’ll find ourselves talking a fair bit about arbitrage over the course of

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These lessons as it’s an important idea in pricing derivatives the key idea being that any two assets with the same cash flows and risk should have the same price hopefully that makes sense to you next we’ll talk about middleman who are our final group of market participants in the derivatives market they’re usually investment banks market makers are brokers

They trade derivatives with the goal of earning a commission or a bid-ask spread between customers who are undertaking opposing positions these market participants typically are not aiming to accurately predict or profit from movements in the price of the underlying they just aim to profit from the commission or spread that they get to charge their customers

While in the ordinary running of their business middlemen can sometimes end up holding a position which might cause a profit or loss they typically doing to avoid this though and will usually hedge any residual exposures they’re left with if at all possible middlemen benefit from churns so they really like a lot of activity in the markets rather than benefiting

From actual accurate predictions of price changes so chances are if you made it this far in the video you’ve found it at least a little bit useful if so please hit the like button below and if you’d like to see more videos like this do subscribe as well i’m gonna make a whole series of these videos in the next one we’re going to discuss the different types of

Financial derivatives available to investors and learn a little bit about the economic function of the derivatives markets see you later bye

Transcribed from video
What Are Financial Derivatives? By Patrick Boyle

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