Key Concepts of Financial Derivatives to Know for Financial Institutions and Markets

Financial derivatives are essential tools in financial markets, allowing investors to manage risk and speculate on price movements. They include forwards, futures, options, swaps, and various securities, each serving unique purposes in hedging and enhancing investment strategies.

1. Forwards

   • Customized contracts between two parties to buy or sell an asset at a specified future date and price.
   • Not traded on exchanges, leading to counterparty risk.
   • Commonly used for hedging against price fluctuations in commodities, currencies, and financial instruments.

2. Futures

   • Standardized contracts traded on exchanges to buy or sell an asset at a predetermined price at a future date.
   • Require margin deposits and daily settlement, reducing counterparty risk.
   • Widely used for hedging and speculation in various markets, including commodities and financial indices.

3. Options

   • Contracts that give the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a specified price before a certain date.
   • Used for hedging, speculation, and enhancing portfolio returns.
   • Can be traded on exchanges or over-the-counter, with varying levels of complexity.

4. Swaps

   • Agreements between two parties to exchange cash flows based on different financial instruments or indices.
   • Common types include interest rate swaps and currency swaps, used for managing interest rate and currency risk.
   • Typically traded over-the-counter, leading to counterparty risk.

5. Credit Default Swaps (CDS)

   • Financial derivatives that allow an investor to "swap" or transfer the credit risk of a borrower to another party.
   • Used to hedge against the risk of default on debt instruments or to speculate on credit quality.
   • Can contribute to systemic risk in financial markets if not properly managed.

6. Collateralized Debt Obligations (CDOs)

   • Structured financial products backed by a pool of loans and other assets, divided into tranches with varying risk levels.
   • Used to redistribute credit risk and enhance yield for investors.
   • Played a significant role in the 2008 financial crisis due to the underlying asset quality.

7. Mortgage-Backed Securities (MBS)

   • Securities backed by a pool of mortgage loans, providing investors with regular income from mortgage payments.
   • Can be agency (government-backed) or non-agency (private-label) securities.
   • Subject to prepayment risk, affecting cash flow and investment returns.

8. Asset-Backed Securities (ABS)

   • Financial securities backed by a pool of assets, such as loans, leases, or receivables, providing cash flow to investors.
   • Used to diversify funding sources and manage risk for financial institutions.
   • Similar to MBS but can include a wider range of underlying assets.

9. Exchange-Traded Funds (ETFs)

   • Investment funds that are traded on stock exchanges, holding a diversified portfolio of assets.
   • Provide liquidity and flexibility, allowing investors to buy and sell shares throughout the trading day.
   • Often used for passive investment strategies and gaining exposure to specific sectors or indices.

10. Structured Notes

    • Debt securities with embedded derivatives, allowing for customized risk-return profiles.
    • Can be linked to various underlying assets, such as equities, interest rates, or commodities.
    • Used by investors seeking tailored investment solutions, but may carry higher complexity and risk.