Meaning of Derivatives

By | April 25, 2021

The financial industry calls derivative financial instruments or derivatives trading constructs to which an underlying asset is based. Securities, commodities, indices or interest rates can be used as underlyings. The value of the derivatives depends on these underlyings.

  • According to digopaul, the derivatives mainly include options, certificates, futures, forex trading and CFDs.
  • Most investors trade in certificates.
  • Bonus certificates involve a high level of risk.

What are derivatives?

The aim of trading with derivatives is to achieve a higher return with a comparably small investment than with the purchase of the underlying asset itself. The most frequently used derivatives include options , certificates , futures , forex trading and CFDs . Critics see these derivatives not as capital market instruments, but as pure financial bets. Investors use these financial products to bet, for example, whether a share will rise or fall.

Warrant trading, futures, forex and CFD are more likely to be used by semi-professional traders or professional investors. The banks have tailored certificates in such a way that the broad mass of investors also feel that they are particularly well served with a certificate. Since investors are now most likely to be confronted with certificates among derivatives, we would like to take a closer look at them at this point.

Certificates

At first glance, a certificate is a fixed-income security, in this case a bond, with a fixed term. The fixed nominal interest rate means that a certificate can be classified in risk class three. How fatal this assignment is is shown by the thousands of investors who have lost their pensions with Lehman certificates.

The rate of return itself is not impressive. The certificate is made attractive by the bonus payment at the end of the term if a certain event occurred or did not occur during the investment period.

Certificates are of interest to banks because, unlike a fund, the paper has a fixed term, usually between 12 and 18 months. The issue surcharge is lower than for a fund, but due to the limited term it always comes into play through new investments – this is the hope of the securities advisors.

This is how bonus certificates work

There are innumerable types of certificates. The easiest way to explain how it works is with a bonus certificate. We take the following example as a basis: The paper has a term of 18 months, the nominal interest rate is 1.5 percent over the entire term, the issue surcharge is 1 percent. It is worth noting that the annual interest rate is only one percent; after deducting the issue surcharge, a guaranteed return of 0.5 percent remains. The certificate is backed by a share A. The issuer of the certificate will take back the paper at a price of 110 percent if the share has not exceeded or fallen below a certain price during the term. This depends on the design of the certificate.

Risk with bonus certificates

However, if the facts relevant for the bonus do not occur, the investor receives the share at the then valid price in his deposit, plus the credit of the interest of 1.5 percent. If the certificate is based on only one share, the risk for the investor is still manageable. However, it looks different with a basket of shares. The higher the number of underlying papers, the greater the risk that a title will not meet the requirements.

Leverage trades: CFDs and Forex

CFDs and Forex are leverage trades. The investor actually uses only a fraction of the capital that he wants to trade, depending on the respective leverage. If this is 1: 200, it is possible to trade an underlying asset for 100,000 euros with an actual capital investment of only 500 euros. The risk, however, lies in a total loss of the capital invested. If the price of the base value goes in the wrong direction for 500 euros, the stake is lost. Trading CFDs and Forex also allows you to bet on falling prices. Because with a leverage transaction, the trader does not acquire the base value, he only bets on its performance .

Futures

From the term it can be read that a future is something in the future. The trader enters into a contract in which he undertakes to buy or deliver a security or good at a certain point in time. For this he pays a so-called security deposit at the beginning, which however only makes up a fraction of the trading volume. In the case of a long position, he speculates that the price will rise by the expiry date of the future and that he will buy cheaper and then sell on immediately at a profit. In the case of a short position, he assumes that the price of the underlying has fallen by the time of maturity and that he is selling at better than market conditions.

DERIVATIVES