Stocks and bonds. Benefits and risks

Let's start with bonds. The easiest way to define a bond is through the concept of a loan. When you invest in bonds, you are essentially loaning your money to a company, corporation, or government of your choosing. That institution, in turn, will give you a receipt for your loan, along with a promise of interest, in the form of a bond.

Bonds are bought and sold in the open market. Fluctuation in their values occurs depending on the interest rate of the general economy. Basically, the interest rate directly affects the worth of your investment.

With bonds, unlike stocks, you, as the investor, will not directly benefit from the success of the company or the amount of its profits. Instead, you will receive a fixed rate of return on your bond. Basically, this means that whether the company is wildly successful or has an abysmal year of business, it will not affect your investment. Your bond return rate will be the same. Your return rate is the percentage of the original offer of the bond. This percentage is called the coupon rate. It is also important to remember that bonds have maturity dates.

Stocks represent shares of a company. These shares give part of the ownership of the company to you, the share-holder. Your stake in that company is defined by the amount of shares that you, the investor, own. Stock comes in mid-caps, small caps, and large caps.

As with bonds, you can decrease the risk of stock trading by choosing your stocks carefully, assessing your investments and weighing the risk of different companies. Obviously, an entrenched and well-known corporation is much more likely to be stable then a new and unproven one. And the stock will reflect the stability of the companies.

Stocks, unlike bonds, fluctuate in value and are traded in the stock market. Their worth is based directly on the performance of the company. If the company is doing well, growing, and attaining profits, then so does the value of the stock. If the company is weakening or failing, the stock of that company decreases in value.

There are various ways in which stocks are traded. In addition to being traded as shares of a company, stock can also be traded in the form of options, which is a type of Futures trading. Stock can also be sold and brought in the stock market on a daily basis. The value of a certain stock can increase and decrease according to the rise and fall in the stock market. Because of this, investing in stocks is much riskier than investing in bonds.

Derivatives. Advantages and disadvantages of every type

Forwards: A forward contract is the customized contract between two parties, where settlement takes place on a specific date in future at today's pre-agreed price. Forwards represent the obligation to make a transaction at a set point in time in the future. Once you enter into a forward-based contract, you are obligated to make the transaction unless both parties agree to cancel or otherwise modify the agreement.

Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. They are unique in terms of contract size, expiry date, asset type and quality.

Forward contracts draw in counter-party risk i.e. the counter-party defaults and is unable to pay the cash difference or deliver the asset.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. When a forward contract is traded on a recognized exchange, it is referred to as a “futures contract". Examples of futures include commodities, interest rates, currencies, and stock market indices.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, an airline uses crude oil futures for hedging purpose to lock in a certain price and reduce risk. Similarly, anybody could speculate on the price movement of crude oil by going long or short using futures. Some future contracts may call for physical delivery of the asset, while others are settled in cash.

Options: An option gives the contract holder the right to buy or sell on a specified date in the future - but they are under no obligation. Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Swaps: Swaps are the types of Forward contracts and they occupy an important role in International Finance. They are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They are generally an agreement to exchange one stream of cashflows to another.

Advantages of Derivatives:

1) Flexibility:

Derivatives can be used with respect to commodity price, interest and exchange rates and equity price. They can be used in many ways.

2) Risk Reduction:

Derivatives can protect your business from huge losses. In fact, derivatives allow you to cut down on non-essential risks.

3) Stable Economy:

Derivatives have a stabilizing effect on the economy by reducing the number of businesses that go under due to volatile market forces.

Disadvantages of Derivatives:

1) Credit Risk:

While derivatives cut down on the risks caused by a fluctuating market, they increase credit risk. Even after minimizing the credit risk through collateral, you still face some risk from credit protection agencies.

2) Crimes:

Derivatives have a high potential for misuse. They have been the caused the downfall of many companies that used trade malpractices and fraud.

3) Interest Rates:

Wrong forecasts can result in losses amounting to millions of dollars for large companies; it can wipe out small businesses. You need to accurately forecast the long term and short term interest rates, something that many businesses cannot do.