Perpetuities and derivatives are forms of investments that are used by individuals and organizations for various purposes. These investments differ considerably in various ways ranging from the cash flows they generate, investment terms, and usage.
What is the meaning of perpetuities?
Perpetuities in finance are used to refer to investments that provide the investor with a recurrent cash flow which is paid out periodically for an infinite amount of time. This means that the payments received from perpetuity investments do not have an end date.
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There are different types of perpetuities, the most common being the delayed and growing perpetuities. Investors that have delayed perpetuity get recurring payments that continue in perpetuity after a defined period without payment.
For example, if Bernice invests in a delayed perpetuity, the cash flow that she will get will begin between a year or up to 10 years after she invested. The period of waiting before the payment begins varies based on the terms of the perpetuity.
A growing perpetuity on the other hand pays the investor an amount that keeps growing at a defined rate for eternity. For example, if Ben invests in a growing perpetuity that has a 5% growth rate, it means that subsequent payments that he receives will always be 5% higher than previous ones.
The perpetuity concept is often applied in valuation analysis to find the terminal value of a company as well as the present value (PV) of its future projected cash flow stream.
What are examples of perpetuity?
Some examples of perpetuities are stocks, real estate, endowment funds, and certain types of bonds.
Although perpetuities are generally considered theoretical because nothing can actually last forever, the above examples are the closest when it comes to paying their holders fixed or growing amounts that are almost perpetual.
Common and preferred stocks that pay dividends to stockholders are considered perpetuities because the stockholders get to receive dividend payments for as long as the companies whose stocks they have continued to be in business and declare dividend payments to shareholders.
Landlords and other property owners usually get rent payments on their properties or land when they lease them out. These payments are also considered perpetuities because as long as the land or building exists, the owner is assured of getting paid rent. Hence, having an infinite stream of cash flow.
Endowment funds which are often used to pay scholarships, sponsor research, or some other philanthropic activities often function as perpetuities. This ensures that a considerable number of individuals or organizations get to benefit from the endowment fund over an extended period.
A certain kind of bond, known as consols which were issued by the government of the United Kingdom in 1751 are an additional example of perpetuities. These bonds had no redemption date and made fixed annual payments to all bondholders.
What are derivatives?
Derivatives are financial instruments that are associated with a specific financial instrument, commodity, or indicator, and through which specific financial risks can be traded in financial markets or over the counter.
The value of a derivative is derived from the price of the underlying item to which it is linked. The underlying assets for derivatives include currency, bonds, market indexes, commodities, cryptocurrencies, interest rates, and stocks.
Financial derivatives serve multiple purposes, including risk management, hedging, arbitrage, and speculation. Risk management is the process of identifying, analyzing, evaluating, and treating potential risks to limit the negative impact on an organization. It involves monitoring risk control and financial resources to mitigate the adverse effects of loss.
Hedging is a strategy that involves making multiple investments to minimize the risk of significant losses. It is done by taking opposing positions in the market simultaneously. Arbitrage is a trading strategy that involves buying and selling the same asset in different markets to profit from the price difference.
Unlike debt instruments, no principal amount is advanced, and no investment income is generated from derivatives. Investors mainly benefit when the price of the underlying assets increases above the stated amount of the contract. Thus, margin traders often use derivatives as a means to get quick cash.
What are the 4 types of derivatives?
The four types of derivatives include swaps, options, forwards, and futures. These derivatives are either traded on the exchange market or over the counter (OTC)
Types of derivatives
Swaps are OTC derivative contracts that normally involve two parties. One party promises to make a series of payments to the other party in exchange for receiving another set of payments from the other party.
These payments are done with an established frequency and respond to interest payments based on the nominal amount of the swap.
There are several types of swaps such as credit default. interest rates, total return, and inflation swaps.
Options are contracts that grant their owners the right to buy or sell a specific number of underlying assets at a predetermined price on or before a specified date.
The predetermined price is known as the exercise price while the specified date is referred to as the expiration date.
Forwards are over-the-counter products that are similar to options, they grant their holders the right to sell or buy the underlying asset at an agreed price on a specific date.
Due to their being traded over the counter, forwards are highly customizable, hence allowing the parties involved in the contract to tailor the terms to their specific requirements.
Futures function in a similar way as forwards, they differ in the fact that they are highly standardized due to their being traded on the exchange market. This endows a high level of liquidity on them as they are often regulated and intermediated.
Differences between perpetuities and derivatives
Although both perpetuities and derivatives are financial instruments, they differ in the following ways:
- Perpetuities do not have an expiration date, which means that for as long as they exist, they are still valid. Derivatives on the other hand have a predetermined expiration date after which they become void.
- Perpetuities do not have underlying assets, instead, their value is directly derived from the existing investment or corporate entity that issues them. Derivatives have underlying assets such as stocks, bonds, or commodities from which their value is derived.
- Perpetuities are not traded on financial markets while derivatives are traded both on financial markets and over the counter.
- The income generated from perpetuities is fixed or growing recurring payments that continue indefinitely. The income, if any, from derivatives usually occurs once at maturity.
- Perpetuities are useful in funding research, retirement, and scholarships. Derivatives are mostly used for speculations.
Summary of differences between perpetuities and derivatives
|Redemption date and expiration
|Do not have a redemption or expiration date.
|Have a specified expiration date
|Useful in planning future cash flows
|Useful in hedging, arbitrage, and speculation
|No underlying asset
|Has underlying assets
|Traded over the counter and on financial markets
|Delayed, growing, and fixed.
|Options, swaps, futures, and forwards.
|Used for long-term planning
|Used for short-term planning
|Real estate, endowment funds, and stocks
|Swaptions, stock options, and commodity futures.
Perpetuities and derivatives similarities
- Perpetuities and derivatives are both forms of investment.
- Both can be used as a means of risk management to hedge against potential losses or market volatility.
- Perpetuities and derivatives are financial instruments.
- Both have various types.
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Perpetuities and derivatives are useful financial instruments that investors and corporate entities utilize for various reasons, such as guaranteeing a consistent future cash flow and hedging against market volatility respectively.
Investing in either perpetuities or derivatives is dependent on the investor’s preferences and financial goals. For instance, while perpetuities are used for long-term plans such as retirement, derivatives are mostly used by investors who want to speculate on the underlying assets and make a profit in the short term.
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