If you manage your own investment portfolio, you know how important it is to balance investment risk with stock returns. Fixed income derivatives are financial instruments whose value is based on, or derived from, an underlying asset. They can benefit your portfolio by reducing transactions costs and improving your trading efficiency. There are various types of derivative instruments that can help you maximize gains and minimize losses in your investments.
When you purchase an option, you pay a fee for the right -- but not the obligation -- to purchase an asset at a certain price, referred to as the option strike price, within a certain period of time. The two main types of options available for purchase are call and put options. The holder of a call option has the right to buy an asset and the holder of a put option has a right to sell an asset. Options can offer protection from price swings by allowing investors to guess, or speculate, on the price movement of a particular investment. If you are able to speculate the correct price movement within a particular window of time, you can realize greater gains and minimize losses on your investments.
Futures contracts are used to promise the delivery at a future date, known as the settlement date, of a financial instrument or commodity at a specified price; the contract can also be settled in cash. Traded on futures exchanges, the value of these contracts change from day to day and an investor can close out the contract before the settlement date. Unlike options, the buyer or seller of a futures contract must carry out the transaction. Depending on your perception of the future direction of prices, you can agree to buy, or “go long,” to profit from an anticipated price increase. If you anticipate a decrease in future prices, you can agree to sell, or “go short,” to profit from an anticipated price decrease.
Forward contracts are similar to futures; they require a future delivery of a commodity or instrument or a cash settlement of the contract, and their objective is to profit from changes in price. Unlike futures, forward contracts are not traded on an established and regulated exchange. Forward contracts typically trade over the counter and are private agreements with more flexible terms. However, the private nature of the contract makes it susceptible to default by either party to the contract. Forward contracts also have one settlement date and delivery of the asset or cash settlement of the contract usually takes place.
Credit Default Swaps
The purchase of credit default swaps is similar to the purchase of an insurance contract. The buyer of a credit default swap receives protection from the possible nonpayment of a debt security. The seller of a credit default swap agrees to pay the buyer a specified amount if the debtor defaults on her payments. This type of derivative is a useful way to transfer an investment’s credit exposure to a third party without having to sell the asset.
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