5: hello and welcome. today we will be

7: providing a brief introduction to

9: financial derivatives. this video is

12: intended only to provide a general

13: picture of what derivatives are. the four

16: most common types of derivatives will be

18: examined in greater detail in

20: standalone videos in the coming weeks.

24: So, what exactly is a financial derivative?

26: well, in its most general sense a

29: derivative is a contract whose value is

31: based on something else. but more

35: specifically the term financial

36: derivative refers to any security whose

39: value is determined by or derived from

41: the value of another asset. the asset

45: from which a derivative gets its value

47: is known as the underlying asset or

49: simply 'underlying'. an underlying asset

52: can take many forms but it commonly

54: refers to stocks, bonds, commodities,

57: currencies, interest rates and market

60: indexes. the most important thing to take

63: away from our discussion of derivatives

65: so far is that their value depends upon

67: the value of something else: the

69: underlying asset. so the change in the

72: value of a derivatives underlying causes

75: the change in the value of the

76: derivative itself. this is all well and

79: good but what's the point of derivatives?

82: well there are two main uses for

85: derivatives.

87: the first is to hedge risk.

91: derivative hedging generally refers to the practice

92: of using derivatives for the objective

95: of minimizing risk in the physical market.

96: in order to demonstrate how a

100: derivative can be used to hedge risk

102: consider the example of wheat producers

104: and cereal manufacturers hedging their

107: exposure to fluctuations in wheat

109: prices. as we know, wheat is susceptible to

113: significant fluctuations in price owing

116: to both supply and demand. A fall in the

120: price of wheat is bad for wheat

122: producers because they can get less

124: money from the crops, but it's good for

127: cereal manufacturers because they can

129: get one of their key inputs at a

130: discount. on the other hand an increase

134: in the price of wheat is good for wheat

136: producers because they can get more

138: money for their crops, but it's bad for

140: cereal manufacturers because it

142: increases costs. so it is in the interest

145: of wheat farmers that the price of wheat

147: remains high but it is in the interest of

149: cereal manufacturers that the price of

152: wheat remains low. now if a wheat producer

156: expects that the price of wheat is about

158: to fall and a cereal manufacturer is of

161: the opinion that the price of wheat is

162: about to rise the two parties can enter

165: into a contract fixing the future price

167: at which the wheat will be sold for

170: example a wheat producer might agree to

173: sell wheat to a manufacturer in six

175: months at the current market price of

177: $12 regardless of what the market price

180: for wheat is in six months. by locking in

183: the price of wheat

185: the producer is seeking to protect his

187: or her self against an expected decrease

190: in the price of wheat. on the other hand

193: the manufacturer is seeking to protect

195: his or herself from an expected increase

198: in the price of wheat. if the price of

202: wheat falls the cereal manufacturer or

205: buyer will wish that they hadn't signed

207: the contract because they could be

209: buying wheat for cheaper had they not

211: signed it. conversely if the price of

214: wheat rises the producer or seller will

217: wish that they hadn't signed the

218: contract because they could be selling

220: wheat for more money had they not agreed

222: to the contract's terms. because the price

226: of wheat can only move in two directions

228: up or down this example is a zero-sum

231: game possessing both a distinct winner

234: and a distinct loser. basically the

237: interest of only the wheat producer or

239: the cereal manufacturer can be met, not both.

242: so in this example a Forward contract

248: was used by both wheat sellers and wheat

250: buyers in an effort to hedge price risk

252: by locking in the price of wheat. we will

255: discuss forward contracts in greater

257: detail in another video but what is most

260: important to take away from this example

262: is the derivatives can be used to hedge

264: risk.

266: the second main use of derivatives is speculation.

269: derivative speculation is

271: fundamentally different from derivative

273: hedging. where derivative hedgers are

276: trying to reduce their risk exposure and

278: usually are not motivated by profit in

280: the derivative market itself derivative

283: speculators are motivated purely by

285: profit seeking. basically hedgers seek to

289: limit risk by using derivatives as

291: insurance policies while speculators are

293: directly driven by the opportunity for

295: profit. now that we have a basic

298: understanding of how derivatives are

300: used, let's take a look at the different types.

302: there are four main types of

305: derivatives: forwards, futures, options and

308: swaps. each of these concepts will be

311: addressed in greater depth in future

313: videos. here our aim is only to provide a

316: basic overview. with this in mind let's

319: begin with forward contracts. a forward

323: is the customized contract between two

325: parties to buy or sell an asset at a

327: specified price at a specified future

330: date.

330: forwards are not traded on a central

333: exchange and as a result they're not

335: standardized or regulated, making them

337: particularly useful for hedging. futures

341: contracts are fundamentally similar to

343: forwards. however, unlike forwards, they

346: are standardized and regulated so that

348: they may be traded on a futures exchange.

351: futures are often used to speculate on

353: commodities. an options contract is a

357: contract to give the right but not the

359: obligation to buy (call) or sell(put) a

363: security or other financial asset.

366: finally, swap is fairly self-explanatory

368: and refers to the exchange of one

371: security for another based on different

373: factors.

375: so we have seen that derivatives are a

378: contract whose value is based on

379: something else. we have seen that they

382: can be used for either hedging or

383: speculating, and we have briefly touched

386: on the four main types. this brings our

388: overview of financial derivatives to a

390: close but please stay tuned for our

393: videos on forwards, futures, options and

395: swaps. thanks for watching and, as always,

400: if you have any further questions please

402: do not hesitate to give us a call or

404: visit our website.