Essay On Derivatives Of Derivatives

In modern times, derivative products have become widely used tools to help investors, organizations and governments manage risk that could arise from factors like unstable commodity prices, changes in currency rates and interest rates in general. A derivative is an asset whose value is derived from the value of an underlying asset that is used to hedge a potentially risky outcome. These underlying assets include a wide range of effects, such as metals, commodities, energy sources and financial assets. Derivatives are evaluated on a balance sheet differently depending their type. This is due to the way they are bought, sold and traded. As such, derivatives come in different variants with the most common being Forwards and Futures Contracts, Call and Put Options and Swaps. This paper will evaluate the potential gains and losses for the different derivative variants while describing their risk potential. As well, this paper will discuss different methods for valuing derivatives.

A forward contract is a contractual agreement made directly between two entities (Chisholm, 2004). Whereas one entity agrees to buy a commodity or a financial asset in the future at a fixed price and the other entity agrees to deliver that commodity or asset at the predetermined price on a specific date. There are no options with this contract. An assets will be bought and sold on the prescribed date for a preset price. This is because both sides are obligated to abide by the terms of the contract. Therein lies the risk associated with forward contract derivatives. Regardless of the value of the commodity or asset on the date of delivery, the commodity or asset must be surrendered. Meaning, the loss or gain in value will affect both the seller and ...

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...riations, a call and a put. A call option gives the holder the right to buy an underlying asset by a certain date at a fixed price. A put option gives the right to sell an underlying asset by a certain date at a fixed price. The person who buys an option will pay a premium to the seller of the contract. “This is because the option provides flexibility; it need never be exercised” (Chisholm, 2004). If a premium was not paid and the option was not excersied, the seller would receive nothing out of the contract. Options are either negotiated between two parties in the over-the-counter market, one of which is normally a specialist dealer, or freely traded on organized exchanges. The evaluation of risk is dependent on where an entity buys the option. There is some customization in options contracts, but general the trade contracts are standardized and thus less risky.