Derivatives I: overview

Financial derivates are used to bet on changes in prices of forward underlying. It usually is cash settled. This is good because now everyone, including the ones who are not living on the underlying but purely traders, can trade it.

Derivative contracts are based on an agreed price, which should match to the forward price. If not, there is "basis risk". Basis risk needs to be hedged too. A common assumption is that basis risk is too small or trivial to be considered.

Derivatives are powerful or efficient, depending on your angle, because of its leverage power. Traders speculate the market by using smaller needed capital. Why does it have leverage? Because derivatives are based on future or expectation of the underlying.

Derivatives use a lot of swaps. Swaps, in a sense, establish a bridge between investment banks and commercial banks. There are equity swap, currency swap, and interest rate swap as the mainstay.

Swap can really lower borrowing costs. For example, a company has US$ debt linking to LIBOR would like to lower its borrowing cost. It can find a European country to issue a dollar bond through a bank. The bank arranges a swap between the fixed rate bond and floating rate borrowing rate. The bank gets fees, the company gets lower rate money, and the issuer gets US$ from the company lower than LIBOR. Everyone is happy.

Derivatives can also manage liabilities.