Derivative Instruments Essay

DERIVATIVE INSTRUMENTS

Derivative instruments are ‘financial contracts whose value is based on, or derived from, a traditional security such as a stock or bond, an asset, such as a commodity or a market index’.

(Campbell R. Harvey). The value of these derivatives is determined by fluctuations in the underlying asset. Derivatives are traded on exchanges like the CBOE, CME and OTC markets.

There are various types of derivative instruments. The most common examples of derivative instruments are options, forwards, futures contracts and swaps. Derivative instruments are used to minimize risks, to speculate and have a view of the future market direction, to lock in an arbitrage profit, to change the nature of a liability

By adopting this approach, an investor can lock in a profit, if the stock price falls during the period of the contract, since he can exercise the option and sell at the strike price. One should not forget however, that hedging involves a cost i.e. the premium that must be paid to buy the put whether you can exercise the option or not.

Options can also be used for speculation i.e. a trader can invest a small amount of money in exchange for a fast and considerable return on his investment. Speculation is usually done by aggressive investors. For example, a trader can write naked puts or uncovered calls on the underlying asset, and if the option expires out-of-the -money, he can retain the premium as profit.

The risk, in this case is that if the option moves in-the-money it will have to be exercised. The speculator might have to purchase the underlying stock and sell it at a lower price than the market price, or, in the case of a put, buy the stock at a price far greater than the market price. The potential losses in this case will be