The non-arbitration price of a derivative contract can be complex and there are many different variables to consider. Pricing without arbitration is a central theme of financial mathematics. For futures/forwards, the price without arbitration is relatively simple, the price of the underlying being linked to the cost of the contribution (income less interest costs), although there may be complexities. Derivatives are contracts between two parties that define the terms (including data, values and definitions of the underlying variables, the contractual obligations of the parties and the nominal amount) in which payments must be made between the parties.   Assets include commodities, equities, bonds, interest rates and currencies, but they can also be other derivatives, which adds an additional layer of complexity to the correct valuation. The components of a company`s capital structure. B such as bonds and equities, can also be considered derivatives, more specifically options, the underlying being the company`s assets, but this is unusual outside the technical contexts. Fortunately for Lenny, derivatives offer another solution. Lenny spint Gail`s loan into a credit derivative and sells it to a speculator at a discount on real value.
Although Lenny does not see the full return on the loan, he recovers his capital and can hand it over to his friend Dale. Lenny loves the system so much that he continues to relocate his credit credits into credit derivatives and earns modest returns in exchange for less default and liquidity. Mortgage-backed securities are another type of common derivatives. In this broad category, the underlying assets are mortgages. Let`s use the story of a fictional farm to explore the mechanics of different varieties of derivatives. Gail, the owner of Healthy Hen Farms, is concerned about recent fluctuations in chicken prices or the volatility of the chicken market due to avian influenza reports. Gail wants to protect her business from another wave of bad news. It meets an investor who enters into a futures contract with it. Derivatives are financial products derived from a relationship with another underlying. These assets are usually debt, commodities, indices or currencies, but derivatives can take a value of almost any underlying. A small percentage of global derivatives are traded on the stock markets.
These public exchanges set standardized contractual terms. You indicate the premiums or discounts on the contract price. This standardization improves the liquidity of derivatives. It makes them more or less interchangeable and makes them more useful for protection. Derivatives can be used as speculative tools or to hedge risks. They can help stabilize the economy, or bring it to its knees disastrously. The famous mortgage-backed securities (MBS), which led to the subprime merger in 2007 and 2008, are an example of derivatives that were defective in their design and destructive in their design. Derivatives are used to transfer the underlying price risks from one party to another.
For example, a wheat producer and a miller could sign a futures contract to exchange a certain amount of cash for a certain amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, price uncertainty and for the miller the availability of wheat. However, due to non-contractual events, such as weather conditions. B, there is always a risk that there will be no wheat available or that a party will withdraw from the contract. Although a third party, a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk.