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UK Financial Services, regulations and ethics

3.2 Financial services products - derivatives

In this section, we describe certain derivatives and consider their potential usage.

Derivatives can be used either as a tool to red...

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...tives are futures, options, warrants and swaps.
Forward Contracts

A forward contract is an agreement to purchase a certain amount of a particular commodity at a specified date in the future at a specified price

Such a contract may give a buyer some security in terms of a definite price in the future but what if that price in the future date turns out to be higher than the market price at that time?

A futures contract will give a buyer the opportunity to “hedge” against price changes.

Futures Contracts

A futures contract is a type of forward contract that is traded on a re...

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...ures can also be used to move quickly between sectors in the market without having to physically buy the underlying assets they follow

A buyer has the obligation to buy an asset at the specified future date and price (long position) and the seller has the obligation to deliver at the specified price (short position)

Futures exchanges operate a clearing house system. The clearing house stands between the buyer and seller and guarantees delivery of goods to the buyer or cash to the seller. This is done by the payment of margins as explained above.

Options give the right (but not the obligation) to sell or buy a commodity, currency or security at a set price at any time within the end of the contract date.

The buyer of the option will exercise it if he is likely to make a profit as a result. If the option is not exercised, it will expire worthless.

There are two types of option:

“Call options” give the owner the option to buy a commodity or security at a specified ...

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...d to pay for the option above its intrinsic value in anticipation of a favourable alteration of the price of the underlying asset prior to its expiry

Options can be traded on the markets without actually being involved in buying or selling the underlying commodity or security. Equally bespoke arrangements can be made between financial institutions which are not readily available to the public. These are known as Over The Counter Options.

...

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... Warrants are a type of option that offer the owner the right to buy the ordinary shares of a company at a fixed price at a fixed date in the future. Warrants can be bought and sold separately on the markets in the same way as options.

A swap is the exchange of a product, interest rate or currency for another product, interest rate or currency

Product swap. For example A...

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...s sterling. The two parties swap their loan facilities. They then have the loan in the currency they want and pay interest in that currency.

The derivative for gilts and fixed interest investments is called a repo (sale and repurchase agreement). This is whe...

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...ial instrument. This allows the purchase of a specific amount of income or capital sum at a selected point in the future.

There are 4 main uses of derivatives as an investment; speculation, risk management (hedging), anticipation of cash flow and arbitrage.

Speculation

A small movement in the value of the underlying asset up or down will produce a large movement in the value of the derivative. For this reason they are normally only used by experienced professional investors.

Risk management (hedging)

Lar...

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...hnique takes advantage of small differences in the pricing of the same asset across different markets. Although the actual price differences can be a fraction of a percent, the gearing up effects of derivatives mean that if an opportunity is found large amounts of the underlying asset can be traded to maximise the amount of profit. This technique is only ever undertaken by specialist professionals.

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