Derivatives
Derivatives are instruments whose value is derived from one or more underlying
financial assets. The underlying instrument could be financial security, a securities
index, or some combination of securities, indexes, and commodities. Derivatives
are financial instruments that have no intrinsic value. Derivatives are financial
contracts whose value is linked to the value of an underlying asset. They are
complex financial instruments that are used for various purposes, including
hedging and getting access to additional assets or markets.
Most derivatives are traded over-the-counter (OTC). However, some of the
contracts, including options and futures, are traded on specialized exchanges.
Types of Derivatives
1. Forwards and futures
These are financial contracts that obligate the contracts’ buyers to purchase an
asset at a pre-agreed price on a specified future date. Both forwards and futures
are essentially the same.
However, forwards are more flexible contracts because the parties can customize
the underlying commodity as well as the quantity of the commodity and the date
of the transaction. On the other hand, futures are standardized contracts that are
traded on the exchanges.
2. Options
Options provide the buyer of the contracts the right, but not the obligation, to
purchase or sell the underlying asset at a predetermined price. Based on the
option type, the buyer can exercise the option on the maturity date or any date
before the maturity.
3. Swaps
Swaps are derivative contracts that allow the exchange of cash flows between two
parties. The swaps usually involve the exchange of a fixed cash flow for a floating
cash flow. The most popular types of swaps are interest rate swaps, commodity
swaps, and currency swaps.
Functions of Derivatives
Price Discovery
The derivative contract helps in determining the prices of the underlying assets.
Future and forward contract prices are used in determining the future spot prices
for the commodity. This way it is beneficial in discovering the prices for underlying
assets
Transfer Of Risk
Derivatives are used for transferring the risk from one party to another that is a
buyer of a derivative product to the seller. It is an effective risk management tool
that transfers the risk from those having a low-risk appetite to those having a
high-risk appetite.
Derivatives are instruments whose value is derived from one or more underlying
financial assets. The underlying instrument could be financial security, a securities
index, or some combination of securities, indexes, and commodities. Derivatives
are financial instruments that have no intrinsic value. Derivatives are financial
contracts whose value is linked to the value of an underlying asset. They are
complex financial instruments that are used for various purposes, including
hedging and getting access to additional assets or markets.
Most derivatives are traded over-the-counter (OTC). However, some of the
contracts, including options and futures, are traded on specialized exchanges.
Types of Derivatives
1. Forwards and futures
These are financial contracts that obligate the contracts’ buyers to purchase an
asset at a pre-agreed price on a specified future date. Both forwards and futures
are essentially the same.
However, forwards are more flexible contracts because the parties can customize
the underlying commodity as well as the quantity of the commodity and the date
of the transaction. On the other hand, futures are standardized contracts that are
traded on the exchanges.
2. Options
Options provide the buyer of the contracts the right, but not the obligation, to
purchase or sell the underlying asset at a predetermined price. Based on the
option type, the buyer can exercise the option on the maturity date or any date
before the maturity.
3. Swaps
Swaps are derivative contracts that allow the exchange of cash flows between two
parties. The swaps usually involve the exchange of a fixed cash flow for a floating
cash flow. The most popular types of swaps are interest rate swaps, commodity
swaps, and currency swaps.
Functions of Derivatives
Price Discovery
The derivative contract helps in determining the prices of the underlying assets.
Future and forward contract prices are used in determining the future spot prices
for the commodity. This way it is beneficial in discovering the prices for underlying
assets
Transfer Of Risk
Derivatives are used for transferring the risk from one party to another that is a
buyer of a derivative product to the seller. It is an effective risk management tool
that transfers the risk from those having a low-risk appetite to those having a
high-risk appetite.
