Financial derivatives are valuable tools that counterbalance the risk factor associated with any form of monetary transaction between two parties. Pension plans and mutual funds constitute as two of the most common examples of financial derivatives in present times.
A brief research on derivatives by Ebele Kemery (a portfolio manager associated with JPMorgan Asset Management) has revealed that these financial instruments are quite similar to electricity which if utilized in the correct manner, can benefit us tremendously but if abused, can cost us heavily.
Financial derivatives cannot be considered as completely unsuitable for all as they promise favorable monetary returns only if you can successfully manage the risk factors associated with the same.
Let us conduct a brief research on derivatives to study its inherent aspects closely:
Chief Role of Financial Derivatives & its types
Derivatives can be referred to a pre-determined contractual settlement between two or more parties concerning their respective financial assets or property. While entering into a formal arrangement of financial product derivatives, the interest rate and mode of repayment are fixed through mutual harmony. Here, the exact amount to be re-paid keeps fluctuating depending on the movement of foreign currency rates. Forwards, options, swaps & futures are 4 main types of financial derivatives.
Let us explore them further:
1) Forwards - They are non-standardized contracts between concerned parties whereby the financial imbursement is carried-out at anytime in the future at an encoded price.
2) Options - Options are financial tools in the form of ‘calls’ or ‘puts’, wherein the buyer of a ‘call’ option is entitled to purchase a part of the primary asset at a certain price in the near future & the buyer of a ‘put’ option is entitled to sell the asset at certain price on or before a certain date in the future without any obligation whatsoever.
3) Swaps - These are formal agreements between two parties in which they concur to exchange finances in the form of cash flows on or before a certain date in the near future.
4) Futures - Futures are very similar to ‘Forwards’ with the only difference being that these are standardized contracts created on-paper by a clearing house and not merely agreed upon by the parties involved.
Basic Misconception about Financial Derivatives
After conducting an in-depth research on derivatives, it has been realized that most people believe this to be a modern concept associated with financial/property transactions. The truth of the matter remains that this theory has existed in human society for many centuries especially with agricultural transactions whereby the price was completely dependent on seasonal changes, hence it was largely unpredictable.
Major Benefits of Financial Derivatives
For years many experts have studied the impact of this particular concept on all kinds of financial and property transactions. On the basis of their research on derivatives, it is confirmed that one of its biggest advantages is reduced percentage of risk factors involved in a financial investment. Financial derivatives are also known to offer variable opportunities to branch out on approximate income, thereby keeping the losses at bare minimum.
Risk Factors Involved with Financial Derivatives
Being a part of the leveraged market, asset liabilities as well as financial derivatives carry potential risks as they come with a fixed expiration date. Most investors fail to comprehend the entire concept of derivatives which is why they end up making poor investment decisions that often result in long-term losses. Financial derivates incorporate important decisions regarding buying and selling assets or properties based on speculation of the future market conditions in order to incur profitable returns. For example, an investor acquires a financial asset at a lower market rate with the intention of selling it in future, speculating that its value would increase in-time. But if he/she is wrong about this conjecture, the chance of incurring losses rises simultaneously.
With potential economic disaster on one end and subsequent rewards on the other, financial derivatives certainly present themselves as hard-hitting, double-edged swords for all kinds of businesses in the current market. It is therefore crucial to get relevant assistance on comprehending this concept entirely before going ahead with the investment strategy.
Ms. Ebele Kemery is a Commodities Leader with a track record of consistently profitable trading efforts and expanded business through understanding of client needs and developing customized solutions that leverage a wide variety of techniques and market intricacies, satisfy all risk management requirements.
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