What are Financial Derivatives?

Financial derivatives are financial by-products extracted from the primary financial instruments. They are products which derive their values from the values of other existing products, without which they cannot exist.

Why Financial Derivative

- Boredom with traditional products
- The need to hedge risks embedded
- The need to generate higher returns on investment
- Making markets more scientific
- Financial Derivatives are about creativity and possibilities
- Reducing the pressure resulting from single products

Types of Financial Derivatives

- Forwards
- Futures
- Options
- Swaps

Forwards: These are transactions necessitated by the need to plan for the future, especially as a way of hedging future risk. It can also be seen as a financial contract where two parties agree to buy and sell a certain amount of the underlying financial asset or Commodity of a specified price and date in the future. The buyer of the Forward is the one who intends to buy the amount of the underlying asset. Example: If Imperial Bakery needs to agree on the price for its flour into the future, and the wheat farmer is concerned about crop turnout and wants to agree on a price for his wheat to the future: they can sign a Forward Contract.

Forwards are over- the- counter (OTC) transactions. The contract is an obligation. Parties cannot change minds and opt out midway. No references but the court.

Futures: An agreement to buy or sell an underlying asset at a particular date and price in the future. It can also be defined as a standardized Forward Contract, traded on the exchange. Example: A month after Imperial Bakery agreed with the farmer for 1000 bushels of wheat at N1, 000.00 per bushel, it realizes the price of wheat will crash to N800.00; though it realizes its mistake, yet he is under obligation Imperial, but.

Options: Options are Financial Instruments that confer the right but not the obligation to buy or sell an underlying asset at a particular price, on or before a particular date. Options are traded/used directly or can be embedded in other financial properties. Exchange traded options, like futures contracts, are standardized. There are also over-the-counter options offered by banks and brokers, which can be customized. The purchase of an option is equivalent to price insurance; therefore there is a price to be paid (just like an insurance premium). Some important definitions regarding options are:

Call: A call option gives the buyer the right, but not the obligation, to buy the underlying futures contract at a predetermined price during a given period of time. Call options are usually purchased as insurance against price increases.

Put: A put option gives the buyer the right, but not the obligation, to sell the underlying futures contract at a predetermined price during a given period of time. Put options are usually purchased as insurance against price declines.
Strike or exercise price: The price at which the futures contract underlying an option can be purchased (if a call) or sold (if a put).

Swaps: A swap contract is an agreement to exchange, or swap, a floating price or rate for a fixed price or rate (or vice versa) for an asset at specific time intervals. A swap is like a series of forward contracts lined up on a schedule, but it does not involve physical exchange of assets. Swaps solve problems relating to the need for longer- term price fixation, but they tend to be credit-intensive and carry the risk of nonperformance.

Benefits of Financial Derivatives – To Investors and to the Economy

- Financial Derivatives meet a crucial economic need by facilitating risk Management, and enabling price discovery. Price discovery occurs when an asset is traded and new information about its value is incorporated into its price.
- Academic research has shown that trading in derivative Markets help Market participants form expectation about underlying asset prices and to manage the risks associated with price changes.
- Financial Derivatives allow risk-averse Market participants (such as banks, farmers, processors and traders) to offset risk among themselves or transfer it to other Market participants willing to accept the risk-return ratio, consequently attracting additional participants who in turn increase the volume of transactions, thus contributing to the creation of a liquid Market.
- Financial Derivative contributes to economic growth in increased liquidity and risk reduction facilities available to portfolio Managers and other investors reduce the cost of capital to business, which ultimately translates into greater capital formation for the economy as a whole.

In conclusion, Financial Derivatives provide risk management tools as well as alternative investment opportunities to Market participants. Their economic role and value-added have been well documented in developed financial Markets, and further evidence is being produced as derivative exchanges are established in emerging Markets.

REFERENCES

Bricheux B., Savre, J.M., and Tachon, L. (1992) Creation of futures: Conditions for success, MATIF S.A., Development and Education Department Paper prepared for World Bank Workshop on risk management in liberalizing Economies, Issues of Access to futures and options Markets, Paris. (Unpublished).

Desmond M.F. (1993) Financial Futures: The Development of Financial Futures Market (pp. 1-4). The Nester House, Playhouse Yard London.

Silber, W.L. (1985) The Economic role of financial futures. In Anne Peck (Ed.), Future Market: The Economic Role. American Enterprise Institute for Public Policy Research (Unpublished).