Types of Derivatives to Include in Your Investment Portfolio
Derivatives come in many varieties, and their value is derived from an underlying asset such as an interest rate, index, or asset. Examples of underlying assets include market indexes, currencies, commodities, bonds, and stocks.
Types of Contracts
There are different financial instruments such as:
Futures are formal contracts to sell or buy some asset at a set price while payment and delivery take place at a future date. The asset can be a financial instrument or a commodity. Forwards are also contracts between sellers and buyers to trade an asset at a pre-agreed price and on a specified date. There are different types of contracts such as over-the-counter, exchange-traded options, real estate and employee stock options. The two parties to the contract are called the holder and the writer. There are different option styles, including exotic, binary, and barrier. Other varieties include the following:
Other Types of Derivatives
There are other types of instruments to include in your investment portfolio. These are mortgage-backed securities, asset-backed commercial paper, and collateralized debt obligations. The latter are in the form of bundle debt, including mortgages, credit card balances, and consumer loans. Other types of financial instruments include foreign exchange, commodity, interest rate, and credit derivatives. Forward exchange contracts, for example, are formal contracts to sell or buy foreign currency on a certain date. The exchange rate is pre-agreed. The non-deliverable forwards contract is one variation. Cross-currency swaps are also used by investors and involve different currencies. Commodity derivatives were created because of problems related to seasonal patterns, delivery methods, storage, and other issues. Rice, soybean, and cotton are examples of commodities that allow this type of trading. The investor buys a contract and not the actual commodity. For example, he buys a contract to sell 2 tons of rice for $5,000. If the current value is $6,500, he can sell the whole amount and make a $1,500 profit. However, if the current value is $4,500, he can sell it at a loss.
When it comes to underlying assets, there are exotic underlyings as well. Examples are economic indicators, freight rates, weather conditions, and others.
Trading and Exchanges
Some instruments are more complex than others. They are traded in two ways – on the stock exchanges and over-the-counter. The exchanges act as an intermediary or a clearing house. They also sell and buy derivative instruments and set discounts or premiums. Stock options and other derivatives are traded on the Chicago Board Options Exchange, NASDAQ, the New York Mercantile Exchange, and CME Group. The contracts include specific settlement and delivery terms.
Benefits for Investors
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