The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. Allows investors to benefit from the price movements of an underlying asset without actually owning the asset. For instance buying a gold is bulky but buying the derivates of a gold's price tracker. The key takeaway is that in the world of derivatives trading, the focus is on contracts and their price movements,
Example:
For example, let's say you're an investor who believes that the price of gold is going to increase in the future. You could buy physical gold, such as coins or bars, and store it in a safe. This would give you direct ownership of the gold, and if the price does indeed rise, you could sell it for a profit.
But owning physical gold can be expensive and inconvenient. You need to store it securely, insure it, and keep track of it. And if you want to sell it, you need to find a buyer and negotiate a price.
A simpler way to benefit from the price movements of gold is to buy a derivative that tracks the price of gold. This could be a gold futures contract, a gold ETF, or a gold mining stock. These derivatives allow you to "gain exposure" to the price movements of gold without actually owning the physical metal.
If the price of gold rises, the value of your derivative will also increase, and you can sell it for a profit. If the price of gold falls, the value of your derivative will decrease, and you can choose to sell it at a loss or hold onto it in the hopes that the price will recover.
These contracts can be used to trade any number of assets and carry their own risks. Prices for derivatives derive from fluctuations in the underlying asset. These financial securities are commonly used to access certain markets and may be traded to hedge against risk. Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation). Derivatives can move risk (and the accompanying rewards) from the risk-averse to the risk seekers.
The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes.
There are two classes of derivative products: "lock" and "option." Lock products (e.g., futures, forwards, or swaps) bind the respective parties from the outset to the agreed-upon terms over the life of the contract.
Option products (e.g., stock options), on the other hand, offer the holder the right, but not the obligation, to buy or sell the underlying asset or security at a specific price on or before the option's expiration date. The most common derivative types 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.
Imagine you're a farmer, and you're worried that the price of wheat might drop before you harvest your crop in three months.
To protect yourself from this price drop, you enter into a "lock" product called a "wheat futures contract" with a buyer (let's say a bakery).
In this contract, you both agree today on the exact price at which you will sell your wheat to the bakery three months from now, regardless of what the market price of wheat is at that time. This is a binding agreement.
If the market price of wheat goes down, you're still obligated to sell your wheat to the bakery at the higher price you agreed upon. You're "locked" into this deal.
Bakery company can accept delivery of the wheat from the seller of the futures contract, but if it no longer needs the wheat, it can also sell the contract before expiration.
In this example, both the futures buyer and seller hedge their risk.
Company Bakery needed wheat in the future and wanted to offset the risk that the price may rise soon.
The farmer concerned about falling wheat prices that wanted to eliminate that risk by selling futures contract
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 a trade where two parties exchange financial terms, such as interest rates, payment schedules, or cash flows, to achieve specific goals or manage financial arrangements.
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. You might do an interest rate swap to make your loan payments more predictable or to take advantage of changing interest rates.
An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation, as futures are. As with futures, options may be used to hedge or speculate on the price of the underlying asset.
Created: 2023-09-20 Tags: #fleeting Link: Derivatives: Types, Considerations, and Pros and Cons (investopedia.com)
