Understanding The Types Of Financial Derivatives

We have been hearing a lot of news about the financial market and financial derivatives. However, its function still remains vague and abstract to many of us.

How do financial derivatives operate?

A financial derivative is a strategy that businesses and companies enter to reduce risks. It is a contract entered by parties that creates a risk and benefit relationship to those involved. From the word itself, a financial derivative is a derived value. This value comes forth from an underlying asset or index. Parties then enter into a contract to be fulfilled at a certain date.

What are the types of financial derivatives?

The concept of financial derivatives is hard to grasp without concrete examples illustrating it. To fully understand how financial derivatives work, let us take a look at the common forms or types of financial derivatives.

1. Forward - This is a form of contract wherein two parties agree on buying or selling an asset at an agreed price. The actual exchange then happens on a future date, thus the term forwards. The contract happens among the parties themselves without an outside party interfering. The contract in a forward type of financial derivative is non-standardized. It is subject to the choices of the parties engaged in a forward contract.

2. Futures - A futures contract is similar in some manner to the forward type. It also involves an agreement on sales of an asset on a future time. However, financial derivatives contracts of this category have a standardized contract form. The terms and conditions of the contract are arranged by a third party called a clearing house.

3. Options - This type of contract allow the person involved to have the option of exercising his right on the assets. Transactions start at a specified price called a strike price. A maturity date is then set for the owner to exercise his option of buying or selling the asset. The owner has the option of using his right on the exact date of maturity and not before in a European option. The American option allows the owner to exercise his right on or before the maturity date.

4. Swaps - Contracts involving swaps allow transactions to occur before a future date. Like all financial derivative types, swaps derive their financial value based on the underlying asset.

The above examples are the most common forms of contracts on financial derivatives. There are many other types that could be made out of a combination of the above examples. When these forms are combined, the contract takes on new features or characteristics that are unique and different from the other forms.

Knowing the types of financial derivatives makes it easier to understand how it works. Now that you know the different contracts involved in financial derivatives, it will be easier to choose an option that suits your need. The concept of financial derivatives may operate on an abstract level but its applications and impact are definitely felt in the real world.