Updated July 17, 2023
Definition of Derivative
The derivative is a kind of financial contract that derives its value from one or more basic variables known as bases where the bases can be any underlying asset, reference rate, or index and the underlying asset includes commodity, equity, stock, currencies, bonds, and forex, etc.
Purpose of Derivatives
The various purpose of entering into derivative contracts is as under:
- Earning Profits: The main aim to enter into the derivative contract is to earn profits by doing speculation on the price of an underlying asset in the future. The market price where securities are traded is volatile where the shares may go up or down. When there is a fall in the share price you may suffer loss and in this situation entering into a derivative contract by placing the accurate bet may help in earning gains.
- Arbitrage Advantage: Arbitrage trading involves a purchase of security in one market at a low price and then selling the same in the other market at a higher price. The difference between the selling price and the buying price will be the profit of the trader.
- To Get Access to Unavailable Markets or Assets: The derivatives help the traders or organizations to get access to the markets or assets that are otherwise not available. For example, interest rate swaps can provide a more favorable rate of interest as compared to the direct borrowings.
- Getting Advantage of Price Fluctuations: Some of people use derivatives for transferring their risks. Moreover, derivatives is used by the people to actually make profits by taking advantage of price fluctuations that too without actually selling off the underlying asset.
Types of Derivative
The different types of derivatives are described below:
1. Futures
Futures are the financial derivatives in which legal agreements are being entered so as to buy or sale a particular derivative stock at the predefined price at the agreed time in the future. Future contracts in order to facilitate its trading over the exchange are standardized. It is the obligation of the buyer to buy the underlying assets upon the expiry of the contract. On the other hand, it is the seller obligation of providing and delivering the underlying asset to the buyer upon expiry of the contract. It allows the investor in speculating in the line of movement of the corresponding underlying stock.
It can be used as a tool to hedge the losses which may happen in stock by entering into future agreement long or short depending on the position of stock held. Futures and future contracts refer to the same thing. The contracts are supposed to be compulsorily squared off on or before the expiry date. If anyone wants to continue the same position even after the expiry date, they can roll over the transaction with the new expiry date.
2. Options
The option is a kind of contract that provides a right but not an obligation to purchase/sell an underlying security at a predetermined price (strike price) and during the specified time period. The buyer of the option is required to pay the premium in order to purchase the right from the seller whereas the seller, also known as the option writer, who receives the premium amount, is under the obligation to sell the underlying security if the right is exercised by the buyer. Options are traded on both over counter market and exchange-traded markets. There are two types of options namely call option and put option. The call option is up side betting and no risk for down fall apart from premium paid loss. In the same line put option is down side betting and no risk for upward movement apart from the premium paid loss.
The options may be bought or laid depending upon the risk appetite of the investor. If option is bought, it is subjected to maximum risk up to the premium paid amount and the profit bracket is unlimited. If the options are being laid or sold, the maximum profit will be the premium paid amount and is subjected to unlimited risk.
3. Forwards
Forward contracts are the customized contract being entered by the parties agreeing to buy or sell a stated asset on a specified date at a specified price. In a forward contract, the buyer make a long position and the seller make a short position. The transactions can be settled by the actual delivery of the agreed item in consideration of the receipt of the agreed cash. It is non-standardized unlike the future contracts and thus makes it a more appropriate tool to be used in hedging. These are not traded in an exchange, rather are traded over the counter. It aims in helping the buyers as well as sellers to mitigate the volatility which is associated with the commodities or other financial investments.
4. Swaps
A swap is a derivative contract between the two counter parties to exchange the financial instrument or payments or cash flows for a certain time. The underlying instrument to this contract can be anything but in maximum cases, it is involved with cash based on a notional principal amount. Every stream of the cash flow is known as leg. This can be used in hedging the risk and minimizing the uncertainty of certain operations. It is traded over the counter and not in exchange. The default risk in the counter party in the swap contracts is very high and thus it is majorly opted by the financial organizations and the companies. The most popular type of swap includes interest rate swap, currency swap, commodity swap, credit default swap.
Conclusion – Derivative Types
Thus, derivatives are the financial contracts whose value is derived from any underlying asset including stocks, bonds, currencies, market indices etc. the value of underlying asset keeps on changing as per the conditions of the market and the main aim of the derivatives is to make profits by speculating on the value of the given asset in future.
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