Derivative instruments are financial contracts whose value depends on another financial asset. Options and futures contracts are the most common derivatives. Such contracts can be used to hedge financial exposure. Hedging refers to the practice of reducing or fully eliminating the risk associated with holding a volatile asset. If used properly, hedging transactions can take a lot of worry and stress out of investing.
A hedge is a financial transaction that reduces or fully eliminates the risk associated with another transaction. For example, an investor holding Microsoft stock may be concerned that the shares will depreciate, but may desire to hold the stock for another six months due to tax reasons. If this investor shakes hands with his uncle to sell him Microsoft stock in exactly six months at the present price, he will fully eliminate the risk associated with holding Microsoft shares. Hedging may always turn out to be a bad idea, as eliminating risk also eliminates profit potential. If Microsoft stock appreciates significantly over the next six months, locking in the current price for the future sale will turn out to be a bad decision.
A futures contract is a legally binding agreement to trade an asset at a future date and a predetermined price. A futures contract can be over the counter or exchange-traded. An over-the-counter futures contract is an agreement to trade assets for a fixed price on a specific future date. An exchange-traded contract, on the other hand, is entered into under the supervision of a regulatory body. The two parties agreeing to trade an asset on a future date must deposit collateral, which eliminates the risk of either party not keeping her promise.
Options are similar to futures contracts in that they lock in a future transaction price. However, executing the trade at that price is mandatory for only one of the parties, while it's optional for the other party -- hence the name. Options come in two flavors: A call option allows the option-holder to buy an instrument if she so desires, while a put option allows her to sell. The option holder can decide whether to engage in the transaction, and could simply ignore the option if she wants to. However, to attain this privileged position, the option holder must pay the option seller an upfront sum. In futures contracts, on the other hand, no money changes hands at the time the agreement is entered into.
Interest Rate Swaps
Interest rate swaps are another hedging instrument. Such agreements stipulate exchanging, or swapping, one type of interest rate payment for another. A corporation may have an obligation to pay floating interest rates to a bank, for example. The company may have borrowed $100,000 and has to make annual interest payments for the next five years, which are determined by the average rates banks are charging on newly initiated loans for that year. To eliminate the risk of having to pay a higher sum as a result of interest rates climbing, the company may sign a swap agreement. The agreement would allow the company to pay another corporation a fixed annual sum and receive in return the floating rate on $100,000, which would exactly equal its obligation to the bank and thus eliminate risk.
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