Financial Derivatives: Futures, Options & Credit Essentials
Concept of Financial Derivatives
Financial derivatives are sophisticated financial products derived from other underlying assets. They serve as hedging instruments to manage or profit from variations in the price of an asset, which in turn depends on other financial variables over time.
Understanding Derivative Markets
Futures markets are term markets for financial assets where the sale price of an asset is contracted in advance for delivery at an agreed future time.
Financial options markets involve contracts that grant parties the right, but not the obligation, to exercise a previously agreed transaction. This means the holder can choose whether or not to execute the contract.
Key Characteristics of Derivative Products
Derivatives possess two primary characteristics:
- They do not involve the immediate sale of an asset, but rather a contract on a determined underlying asset for a future date.
- The purchase price of the derivative contract is dependent on the price of another asset, which underpins the operation.
Functions of Derivative Products
Derivatives serve three main functions:
- They cover risks (hedging).
- They provide investment opportunities.
- They facilitate speculation.
Futures and Options: Detailed Concepts
Understanding Futures Contracts
A futures contract is a financial product that formalizes the agreement to buy or sell an asset at a specific price on a future date. In the futures market, a disbursement is typically required: for example, 16% of the contract value for a purchase and 10% for a sale.
Understanding Options Contracts
An options contract grants the holder the right, but not the obligation, to perform a specific transaction on a financial asset by a certain date. This distinction is crucial: the right exists, but the obligation does not. Therefore, if exercising the option is not beneficial to the policyholder, they can choose not to. In such a case, the only loss incurred is the premium paid for the option itself.
Credit Evaluation: Scoring and Commercial Credit
Understanding Credit Scoring
Financial institutions utilize a risk evaluation method called scoring to assess loan applications. This method assigns points to applicants based on various factors such as age, marital status, profession, and more. While not always the sole decisive factor, this score significantly aids the entity’s decision-making process.
Commercial Credit Operations
Commercial credit generally refers to operations like discounting by financial institutions or the financing of sales and service provisions.
Simple Discount Explained
Simple discount is a financial operation that updates simple financial capital, replacing a future value with a present one. It is the reverse of simple capitalization. Financial intermediaries charge an amount of interest, which is deducted from the outstanding nominal amount due.
Risk in Discount Operations
In discount operations, banks are concerned with security risk. The risk for the entity is smaller when more people are obligated to the debt. Banks often prefer to guarantee those who are not already accepted or have a lower risk profile. Another crucial factor considered is the client’s percentage of bad debt.
Calculating Discount Interest
The interest charged by the entity for advancing money through discounting is determined by the nominal value of the effect (C), the applicable interest rate (i), and the time remaining until the document’s expiration.