Derivatives are financial contracts whose value is dependent on an underlying asset or group of assets. The commonly used assets are stocks, bonds, currencies, commodities and market indices. The value of the underlying assets keeps changing according to market conditions.
The basic principle behind entering into derivative contracts is to earn profits by speculating on the value of the underlying asset in future. Imagine that the market price of an equity share may go up or down. You may suffer a loss owing to a fall in the stock value. In this situation, you may enter a derivative contract either to make gains by placing an accurate bet.
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In finance, there are four basic types of derivatives: forward contracts, futures, swaps, and options. A derivative is a financial instrument that derives its value from something else.
The value of a derivative is linked to the value of the underlying asset. In simpler terms, think of putting down a bet on a hand of blackjack as the underlying and then someone else making a bet on the success of your blackjack hand as a derivative of the underlying.
There are generally considered to be 4 types of derivatives: forward, futures, swaps, and options. If this happens, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros.
A speculator who expects the euro to appreciate compared to the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have a holding or portfolio presence in the underlying asset. Many derivative instruments are leveraged, which means a small amount of capital is required to have an interest in a large amount of value in the underlying asset.
Derivatives are now based on a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region. There are many different types of derivatives that can be used for risk management , speculation , and leveraging a position. The derivatives market is one that continues to grow, offering products to fit nearly any need or risk tolerance.
The most common types of derivatives are futures, forwards, swaps, and options. A futures contract , or simply futures, is an agreement between two parties for the purchase and delivery of an asset at an agreed-upon price at a future date.
Futures are standardized contracts that trade on an exchange. Traders use a futures contract to hedge their risk or speculate on the price of an underlying asset. The parties involved are obligated to fulfill a commitment to buy or sell the underlying asset. For example, say that on Nov. The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy.
Company A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits. In this example, both the futures buyer and seller hedge their risk.
Company A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract. The seller could be an oil company concerned about falling oil prices and wanted to eliminate that risk by selling or shorting a futures contract that fixed the price it would get in December.
It is also possible that one or both of the parties are speculators with the opposite opinion about the direction of December oil. In that case, one might benefit from the contract, and one might not. Not all futures contracts are settled at expiration by delivering the underlying asset.
If both parties in a futures contract are speculating investors or traders , it is unlikely that either of them would want to make arrangements for the delivery of several barrels of crude oil.
Speculators can end their obligation to purchase or deliver the underlying commodity by closing unwinding their contract before expiration with an offsetting contract. Many derivatives are in fact cash-settled, which means that the gain or loss in the trade is simply an accounting cash flow to the trader's brokerage account. Futures contracts that are cash-settled include many interest rate futures, stock index futures , and more unusual instruments like volatility futures or weather futures.
Forward contracts or forwards are similar to futures, but they do not trade on an exchange. These contracts only trade over-the-counter.
When a forward contract is created, the buyer and seller may customize the terms, size, and settlement process. As OTC products, forward contracts carry a greater degree of counterparty risk for both parties.
Counterparty risks are a type of credit risk in that the parties may not be able to live up to the obligations outlined in the contract. If one party becomes insolvent, the other party may have no recourse and could lose the value of its position.
Once created, the parties in a forward contract can offset their position with other counterparties, which can increase the potential for counterparty risks as more traders become involved in the same contract. Swaps are another common type of derivative, often used to exchange one kind of cash flow with another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.
XYZ may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable rate risk. Regardless of how interest rates change, the swap has achieved XYZ's original objective of turning a variable-rate loan into a fixed-rate loan.
Swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a loan or cash flows from other business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative. Large speculative plays can be executed cheaply because options offer investors the ability to leverage their positions at a fraction of the cost of an underlying asset.
Derivatives can be bought or sold in two ways— over-the-counter OTC or on an exchange. OTC derivatives are contracts that are made privately between parties, such as swap agreements, in an unregulated venue.
On the other hand, derivatives that trade on an exchange are standardized contracts. There is counterparty risk when trading over the counter because contracts are unregulated, while exchange derivatives are not subject to this risk due to clearing houses acting as intermediaries. There are three basic types of contracts. Options are contracts that give the right but not the obligation to buy or sell an asset.
Investors typically use option contracts when they don't want to take a position in the underlying asset but still want to increase exposure in case of large price movement. There are dozens of options strategies but the most common include:.
Swaps are derivatives where counterparties exchange cash flows or other variables associated with different investments. A swap occurs many times because one party has a comparative advantage , like borrowing funds under variable interest rates , while another party can borrow more freely at fixed rates. The simplest variation of a swap is called plain vanilla—the most simple form of an asset or financial instrument—but there are many types, including:.
Parties in forward and future contracts agree to buy or sell an asset in the future for a specified price. These contracts are usually written using the spot or the most current price.
The purchaser's profit or loss is calculated by the difference between the spot price at the time of delivery and the forward or future price. These contracts are typically used to hedge risk or to speculate. Futures are standardized contracts that trade on exchanges while forwards are non-standard, trading over the counter. Investors looking to protect or assume risk in a portfolio can employ long, short, or neutral derivative strategies that seek to hedge, speculate, or increase leverage.
The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a broader portfolio strategy. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.
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