Derivatives

What is a Derivative?

Contracts that drive value from their underlying assets are known as derivatives. Investors use different types of derivatives to speculate. These financial contracts depend on stocks, bonds, commodities, currencies and market indices. If you’re looking to enter into the derivative contract market, you have to speculate on the value of the underlying assets. Now, let us look at the different types of derivatives contracts.

Futures Contracts

One of the most common types of standardized contracts is the futures contracts. These contracts allow the holder to sell or buy assets. The contract is bought or sold at a price agreed by both parties on a specific date. It is traded on the stock exchange, and the value is adjusted as per the market till the expiry date. Both the parties to the contract are obliged to perform the contract on a future date.

Equity Options

Another contract type is equity options. The options give the buyer the right to buy/sell the underlying assets. The contract holder can sell the underlying assets at a fixed price known as the strike price. The trade is completed within a certain time period, but there is no obligation. The main difference between futures contracts and equity options is that the latter involves no obligation.

Derivative Exchanges and Regulations

Derivatives are traded on different exchanges. For instance, some are traded on the national securities exchange, whereas others are traded over the counter.

Example of Commodity Derivative

Commodity derivative or commodity futures contracts are brought or sold at a preset price. These contracts are used to protect investors and businesses from market fluctuations.

For example, when a farmer and miller enter a commodity contract. The farmer enters the contract to get a good price for his commodities, whereas the miller seeks a guaranteed commodity supply. However, both parties are exposed to risks from preset prices. This means that when the prices rise the farmer loses additional income. And when the prices drop, the miller has to pay more, which leads to him losing money.

Benefits of Derivatives

Derivatives offer a lot of benefits to the financial markets.

• One of the most important benefits is that it helps to determine the price of the underlying assets.
• As derivatives are linked directly to the underlying assets, they are effective in hedging risks.
• Derivatives are a great way to improve financial marketing. You can access unavailable assets with the help of derivatives.
• Organizations/businesses can use interest rate swaps to leverage favorable interest rates when compared to direct borrowing.

Derivatives and Hedging

Derivatives are contracts between the two parties whose value depends on the underlying assets, while hedging is often used to protect one investment by undertaking another investment. Many companies use derivatives to hedge against market risk. Here, the company needs to use derivative contracts to mitigate financial risk associated with investing.

Derivative Swap

A derivative swap is a derivative contract in which two parties can exchange cash or liabilities with each other. This is done by using a financial instrument, but it is not traded on exchanges. Swaps are categorized as  over the counter contracts that are customized as per the needs and preferences of both parties.

Credit Derivative

Credit derivatives are contracts whose value depends on the credit of two or more underlying assets. This derivative option allows parties to transfer risks to a third party. For this, they pay a fee known as a premium. This  derivative option includes credit default swaps, total return swaps, credit default swap options, collateralized debt obligations and credit spread forwards.

Frequently Asked Questions