Derivative tools are financial instruments

  • August 2, 2021

Derivative tools are financial instruments that are mainly based on an underlying asset or derived from them. In other words, their value derives from the value of another asset. Assets that can be used as base assets in these instruments include types of stocks, interest-rate instruments affected by interest rate fluctuations, foreign exchange market instruments, types of goods, specific and special credits, and small and large loans. Before we explain these tools in more detail, we will have an overview of the philosophy behind the formation of these tools., in the following articles, The position of these tools in the domestic financial market will be discussed in detail.

Philosophy of derivative tools

The purpose of investing is to make society more prosperous and comfortable by allocating resources and facilities optimally. Business owners, entrepreneurs, and governments need financial resources to produce goods and services so that they can implement investment projects and respond to the growing needs of society by building factories and developing new products. The financial resources available to these people alone do not cover the costs of investment projects but need to involve other people in the community through their savings. Has, guided. 

For this purpose, different substrates must be provided. One of the most important of them is creating markets and financial institutions that act as an intermediary between lenders and borrowers and facilitate the capital formation process with various functions that are manifested in facilitating the transfer of funds and liquidity. In addition to the recent cases, it is necessary to systematize how the government and companies borrow from the public and their participation in the future benefits of investment projects. Financial instruments do this important thing.

Financial instruments represent a kind of claim to the future benefits of an asset that will bring a certain income to the holders in the future. Stocks and bonds are among the simplest forms of financial assets commonly used to transfer funds between lenders and borrowers. In a simple financial environment, risk management is limited to stock and bond trading. For example, the manager of a portfolio may have a portfolio of risky stocks and risk-free bonds and adjust the weight of each of these two types of assets according to the riskiness of the investors. If the portfolio manager wants to reduce the risk, the only possible transactions in this regard are to reduce the weight of the risky asset, to sell the shares in the portfolio, and to add risk-free bonds.

But the reality is that we live in a complex world where stocks and bonds are not the only tools available to investors. Investors can adjust the level of risk and return on their portfolio in a variety of ways with the tools created by financial engineering. One of the common strategies in financial engineering and risk management is the use of derivatives. In fact, financial markets have paved the way for insurance against financial losses through so-called “derivative” contracts. Derivatives are considered as risk management tools in financial markets

Types of derivatives tools based on asset

Derivatives are an agreement between two parties that each agrees to do something for the other at a specific time in the future. Derivatives are financial instruments that derive most of their value from an underlying asset, reference rate, or index. As can be seen from the above definition, the performance of a derivative instrument is affected by the performance of the underlying asset.

Derivatives may be based on real assets or financial assets:

  • Real assets are tangible and physical assets and include commodities such as agricultural products, metals, and energy resources.
  • Financial assets include items such as stocks, bonds, loans, and foreign exchange.

History

Derivative markets have a long and interesting history. Examining the history of these markets enables us to have a better understanding of the structure of today’s markets. On this basis, perhaps the main features of derivative contracts can be found in human history. The history of “agreements” for doing business, as well as the existence of an agreement to gain the right to do business in the future, goes back hundreds of years.  In the Middle Ages, the use of contracts for the delivery of assets in the future at a fixed price that was set at the time of the contract was very common. The first signs of the emergence of the futures market were seen hundreds of years ago in Japan. However, the origins of financial markets are mostly attributed to 1848, when the Chicago Board of Trade became the first systematic futures market. Originally, the market was set up for grain trading, according to which farmers stabilized the sale of their crops for the future with price and time conditions. At the same time, the idea of enforcing custom transaction contracts was put forward by 

named Russell Sage well-known financial expert. The growth of futures contracts accelerated in the twentieth century. In the next steps of the Chicago Board of Trade, the Chicago Mercantile Exchange and then the New York Mercantile Exchange as well as the Chicago Mercantile Exchange became the most influential factors in the world derivatives markets. These exchanges created and temporarily initiated a large number of derivative contracts. Although in the first century from the beginning of futures trading, these contracts were executed on agricultural products, but in the 1970s, financial markets saw the introduction of derivatives trading on financial instruments such as bonds, currencies, and stock indices. However, derivatives trading in commodities, especially commodities such as oil and precious metals, is still active in the market today; But the main focus of transactions is on financial derivatives

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