Part 25: Derivative Financial Instruments

When learning about financial markets, you may have come across the term “derivative instruments.” At first, it might sound complicated, but in reality derivatives are simply financial contracts with certain conditions. In this article, we will explain what derivatives are and how they work.

What is a derivative financial instrument?

A derivative is a contract whose value depends on the price of another underlying asset. That underlying asset of the contract may be a stock, bond, commodity (such as gold or oil), a currency, or even a market index (such as the S&P 500).

It is important to understand that the investor does not own the underlying asset itself. They only hold the contract, which gives them the right or obligation to buy or sell the asset at a specific price in the future.

Simply put, a derivative is an agreement about a future transaction.

Derivatives are complex and risky instruments. They are usually suitable for experienced investors. However, understanding them is important for anyone who wants a complete picture of investments and financial markets.

What are derivatives used for?

Derivatives are mainly used for two purposes:

• Risk management (hedging)

This is the most common use of derivatives, where investors protect themselves against potential losses.

• Gaining profit from price movements

An investor can speculate on the movement of prices and try to make a profit without owning the underlying asset itself.

Examples by type of derivative

Forwards and Futures

These are contracts in which the parties agree to buy or sell the underlying asset at a predetermined price at a future date. Futures are traded on exchanges and have standardized terms, while forwards are customized agreements between two parties.

Example: An oil-importing company wants to protect itself against a possible price increase. It buys an oil futures contract that fixes the price of one ton of oil, but the delivery will take place in three months. If the market price rises during that period, the company will still be able to buy the oil at the previously agreed price.

Options

These are contracts that give investors the right, but not the obligation, to buy or sell the underlying asset at a specific price.

Example: An investor believes that the price of “ABC” company’s stock will rise. He pays $10 for an option that gives him the right to buy one share of the company at $100. If the market price rises to $120, he can buy the share for $100 and immediately sell it for $120, making a profit. If the price does not rise and stays below $100, the investor will simply not exercise the option, and his loss will be limited to the $10 he paid for the option.

Swaps

These are contracts in which two parties exchange cash flows. 

The most common type is the interest rate swap, where one party pays a fixed interest rate and the other pays a floating rate.

Example: A company has taken a loan with a floating 6% interest rate. This means that if market interest rates increase, its repayment amount will also increase, making its expenses unpredictable. Let’s call it Party A, which has borrowed $10 million at a 6% floating rate. Party B, on the other hand, has fixed-rate obligations at 5%.

Under the swap agreement, Party A pays Party B a fixed rate, while Party B compensates Party A for the difference in the floating rate.

In effect, Party A “exchanges” its floating interest rate for a fixed one. As a result, it can be sure that it will always pay 5%, even if market rates rise to 7%. If in a given month the floating rate rises to 7%, the difference of 2% is covered by Party B. If the rate falls to 4%, Party A pays the difference to Party B.

Apricot Capital is regulated by the Central Bank of Armenia.

The examples in this text are for illustrative purposes only. This does not constitute investment advice or a recommendation to buy or sell any specific investment instrument. The past performance mentioned in this text is not indicative of future results.