The Finatical
Week of September 6th, 2021 - Understanding Derivatives, Unexpected August Jobs Report, China's Surge in Trading Volume
FinaticTips - 3 Tips to Understand Derivatives
Derivatives…fancy word huh? Let’s dive into it.
What are Derivatives?
Before you throw your laptop away, let me assure you that we are not talking about the cumbersome calculus concept that has got almost every teenager regretting his/her life choices. In financial terms, a derivative is a complex financial security or contract between two or more parties and is used by traders to assess specific markets and trade different assets. The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. Contract values depend on changes in the prices of the underlying asset.
The assets are usually traded on exchanges or over-the-counter (OTC) and are purchased through brokerages. These transactions tend to have an element of risk involved, especially OTC-traded derivatives. These derivatives are risky as there is a higher possibility of counterparty risk, which is the danger that one of the parties involved in the transaction might fail to repay the debt.
Types of Derivatives
The most common types of derivatives are:
Futures
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract takes on the obligation to buy and receive the underlying asset when the futures contract expires while the seller of the futures contract takes on the obligation to provide and deliver the underlying asset at the expiration date. This contract is very similar to an option and traders use it to hedge risk while buying an asset in the future. A buyer might feel that the prices of a commodity can rise in the future and can secure the price at which he can buy it in the future while the seller of that commodity might feel that the price of the commodity will fall in the future and by signing a futures contract, he is ensuring that he sells off the commodity at the current price. In this manner, a futures contract satisfies both.
Speculators can end their obligation to purchase or deliver the underlying commodity by closing (unwinding) their contract before expiration with an offsetting contract.
Forwards
Forward contracts or forwards are similar to futures, but they do not trade on an exchange. These contracts only trade over-the-counter. When a forward contract is created, the buyer and seller may customize the terms, size, and settlement process. As OTC products, forward contracts carry a greater degree of counterparty risk for both parties.
Swaps
A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter(OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties.
Options
An option is a contract that gives the bearer the right — but not the obligation to — buy or sell an underlying asset at a predetermined price over a specified period of time.
The key difference between options and futures is that with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation, as futures are. As with futures, options may be used to hedge or speculate on the price of the underlying asset.
Pros and Cons
Pros:
Lock in prices
Hedge against risk
Can be leveraged
Diversify portfolio
Cons:
Hard to value
Subject to counterparty default (if OTC)
Complex to understand
Sensitive to supply and demand factors
FinaticTrends - 2 Financial Trends
1 - Unexpected August Jobs Report
The US August job report did not meet expectations as the economy just added 235,000 people to the workforce as opposed to the expected 733,000 payrolls. This report seems unusual as the unemployment rate lines up with the expected 5.2%. So what might be the reason for this labour shortage? Evidently, the problem is not labour demand as businesses and companies are still looking to hire more people. The problem lies with the labour supply and the central cause of this problem is the Delta variant of Covid-19. With the new surge in Covid-19 infections, potential workers are backing down from the employment race and that is the reason why the numbers are so low. It seems like if the necessary precautions are taken to curb Covid-19 infections, the US will be back on track to economic recovery. Even though the job numbers stooped very low this August, the US economy was not affected as much and it seems like the economy is still very steady. However, the US government will have to take decisions to ensure that this minor bump in the road doesn’t escalate to a whole new catastrophe.
2- China’s Surge in Stock Trading Volume
As the Chinese authorities continue to maintain a tight hold on other investment alternatives like real estate and cryptocurrency, the Chinese daily trading volume climbed to a high for the year of 1.71 trillion yuan on Wednesday. These statistics are surprising as the Chinese stock market crashed under high speculation just six years ago in 2015. More people are likely to focus their money on the stock market amid a surge in real estate prices and a tightened ban on cryptocurrency transactions. Economists believe that more money will come into the stock market, especially as uncertainty over economic growth has investors expecting that monetary policy will only get looser, allowing more capital to flow. Beijing’s curbs on the property sector, which makes up one-quarter of China’s economy and half of the global construction business, are likely to force residents to make some economic decisions. It will be interesting to see how the stock market outlook changes over the next few months.
Financial Guidance
“Don’t tell me what you value, show me your budget, and I’ll tell you what you value.” ― Joe Biden
Money Fact
America's three richest billionaires — Jeff Bezos, Bill Gates, and Warren Buffett — own as much wealth as the bottom half of all US households combined.
Umm..that’s crazy.
 |
|