Financial derivatives are investment instruments that have gained popularity in recent decades. According to the National Banking and Securities Commission (CNBV), the derivatives market in Mexico has experienced significant growth, with a 15% increase in the volume of contracts traded in 2021.

 

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What are Financial Derivatives and what are they used for?

Financial derivatives are contracts whose value depends on an underlying asset, which may be a stock, a currency, an interest rate, among others.

These instruments allow investors to hedge against market risk, speculate on price movements or take advantage of arbitrage opportunities.

How are Financial Derivatives classified?

Financial derivatives can be classified in several ways, but the most common are:By the type of underlying asset.This includes derivatives on stocks, indexes, currencies, interest rates, commodities, among others.

  1. By trading venueA distinction is made between derivatives traded on organized markets (futures and options) and those traded on OTC markets (forwards, swaps, exotic options).
  2. By the commitment made by the partiesIn this case, a distinction is made between firm commitment derivatives (futures, forwards) and conditional commitment derivatives (options).

Examples of Financial Derivatives

Below are some examples of financial derivatives:

  1. IPC FuturesThis is a contract that obligates the parties to buy or sell a determined number of contracts of the Mexican Stock Exchange’s Price and Quotations Index (IPC) on a future date at an agreed price.
  2. Options on América Móvil sharesThis is a contract that gives the buyer the right, but not the obligation, to buy or sell América Móvil shares at an exercise price on a future date.
  3. Interest rate swapsThis is a contract in which two parties agree to exchange cash flows based on a notional principal amount and two interest rates, one fixed and one floating.

Why are Financial Derivatives important?

Financial derivatives are an essential tool for risk management in the financial world.

They allow companies and investors to protect themselves against fluctuations in prices, interest rates and exchange rates, thus contributing to the stability of the financial system.

In addition, financial derivatives offer opportunities for investment and speculation, which can result in high returns for investors who are willing to assume greater risk.

What are the risks of investing in financial derivatives?

Investing in financial derivatives can be an effective strategy to maximize returns and mitigate risks, but it also carries certain risks that investors should be aware of:

  1. Market volatilityFinancial derivatives are subject to market volatility, which may result in significant fluctuations in the value of these instruments.
  2. Leverage riskLeverage risk: Since financial derivatives allow leverage, it is possible that losses may exceed the initial capital disbursed.
  3. ComplexityFinancial derivatives are complex products that require a thorough understanding of how they work, the markets in which they operate and the risks involved.
  4. Counterparty riskThere is a risk that the counterparty to a derivative contract will not meet its contractual obligations.
  5. Liquidity riskSome derivatives may be difficult to sell or liquidate quickly, especially in times of market stress.

 

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How can I mitigate risks when investing in derivatives?

Mitigating risks when investing in financial derivatives involves a series of prudent strategies and practices. Here are some tips:

  1. Understanding DerivativesBefore investing, it is crucial to understand how financial derivatives work, the markets in which they operate and the risks involved.
  2. DiversificationAs with any investment portfolio, diversification can help mitigate risk. Don’t put all your eggs in one basket.
  3. ResearchConduct thorough research before investing. This includes understanding the credit ratings of bond issuers before investing.
  4. Financial adviceConsider consulting a financial advisor for expert guidance.
  5. Efficient use of capitalDerivatives offer leverage, which means that you do not have to pay the purchase and sale price at the beginning of the transaction. This allows you to make use of the resources you currently have to meet needs and cash flows, and thus take advantage of other investment opportunities.

Constant monitoringIt is important to periodically review your investments to make sure they are still in line with your objectives.