A derivative can be defined as a security whose price depends on or derives from one or more underlying assets. Very simply, is a contract between two or more parties. The value of a derivative is determined by fluctuations in the underlying asset. These assets include stocks, bonds, currencies, commodities, stock indices and interest rates.
A small movement in the value of the underlying asset can cause a large difference in the value of the derivative. In this way derivatives can provide leverage to an investor.
Derivatives are mostly used as a means to hedge risk. Hedging is a technique that attempts to reduce risk. This means that derivatives can be considered to be a form of insurance.
Derivatives allow risk to the price of underlying assets to be transferred from one party to another. Thus, when two parties sign a contract, one party is the insurer of a type of risk and cons-revolutionary party is the insurer of a second type of risk.
Hedging can also occur when an individual or institution buys a commodity or a stock that pays dividends and sells it using a futures contract. The individual or institution will then have access to the asset for a specified amount of time, and can sell it in the future at a specified price according to the futures contract.
Derivatives can also be used to take risk rather than to hedge risk. An investor can enter into a futures contract to speculate the value of the underlying asset. He will then bet on whether the party seeking insurance will be wrong about the value of the asset in the future.
In this way, a speculator can buy an asset at a low price in the future when the market is high. Similarly, speculators can sell an asset at a high price when the futures market prices are low. This buying and selling of risk is considered to have a positive impact on the economic system.
The common derivative contracts are futures contracts, options and swaps.
A futures contract is a contract between two or more parties to trade a certain asset at a specified date in the future at the price agreed on today. Swaps are contracts to exchange cash on or before a certain future date. Cash is exchanged based on the underlying value of commodities, stocks, exchange rates or other such assets.
Options give the owner the right but not the obligation to buy or sell an asset. The sale takes place at a certain price called the strike price. This price is specified when the parties enter into the contract. This contract will also specify a maturity date.
There are five major classes of underlying assets. These are interest rate derivatives, foreign exchange derivatives, credit derivative, equity derivative and commodity derivatives.
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