Derivatives



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Just a couple of years ago, the whole world was engulfed in one of the worst financial crisis of all times: Sub-Prime crisis. There were many factors responsible for the sub prime crisis. One of the important factors that complicated the nature of crisis was the use of the products called Derivatives. People plunged into them, attracted by their high yields without understanding the underlying risks. The intricacies associated with these products can only be understood by financial wizards. Let us make an effort to understand what these products mean in layman terms.

 

There are mainly two types of derivative products:

Financial and Credit derivatives.

 
A financial derivative is a product whose value is derived from the value of one or more basic variable (underlying asset, index or reference rate) in a contractual manner. It has no value of its own but derives its value from underlying asset. The typical underlying assets include: Stocks, Interest rates, Currencies and commodities. An underlying asset could again be a derivative. The complexity involved in particular derivative product depends upon the underlying asset and the payout function. Some of the examples of financial derivatives include: forwards, futures, options and swaps. In forwards and futures, the buyer of the contract involved fixes the value of underlying asset on a future date. The seller delivers the asset on that future date. While forwards are over the counter products, futures are exchange traded. In swaps, the exchange of cash flow happens between the buyer and the seller over a period of time. While options are again of two types: call and put. In these you have the option to buy/sell an asset on a future date. It is kind of impossible to state how they are priced and various other details built in the contract in a small write-up as this one. So, let us have an overview of the other type of derivatives now. 


Before we understand what credit derivatives are, let us understand what we mean by credit risk. Suppose you gave a loan to somebody. Now there is a possibility that he might not be able to repay your. So, Credit risk is the risk that the borrower may not be able to meet the contractual obligation to repay. While there are traditional methods to mitigate credit risk (fixing of exposure limits and concentration limits, assigning credit ratings, risk based pricing etc), the credit derivatives are used to basically transfer the risk. Credit derivatives are the financial contracts that allow one party to transfer credit risk (losses due to credit events on an underlying reference asset), and thereby the return of a reference credit asset to another party. Both the risk and returns are transferred or sold off to another party. The reference assets that are generally involved are: bank loan, corporate bond, sovereign debt etc. Some of the examples of credit derivatives are: Credit Default Swaps, Total return swaps, basket default swaps, Credit Spread Options and Credit Linked Notes etc.


Derivatives are popular far and wide in the financial world owing to their advantages. The most important advantage of derivatives is hedging. It allows the buyer of derivative product to fix the value of a certain future cash flow. So, it provides protection against losses resulting from unforeseen price changes. Secondly, derivatives are highly leveraged products. Thereby, it allows investors to make large investments by bringing in only the margin money. But then again derivatives are highly risky products and must be used with prudence. The risks involved are huge. If the market goes in the opposite direction of your projection, derivatives could play havoc on your finances and wipe you away. So, before you start speculating with them, get some lessons to become a financial wizard