What are Derivatives?

About Derivatives:

• A derivative is a contract between two parties which derives its value/price from an underlying asset.
• The commonly used assets are stocks, bonds, currencies, commodities and market indices.
• These instruments allow investors and traders to speculate on the price movements of the underlying asset without owning it directly.
• 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.
• Derivatives serve various purposes, including hedging against risks, providing leverage, and facilitating price discovery.
• The most common types of derivatives are:
  • Futures Contracts: A futures contract is an agreement between two parties to buy or sell an asset at a predetermined price on a specific future date. The underlying asset can be commodities, financial instruments, or indices.
  • Options Contracts: An options contract gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (strike price) on or before a predetermined expiration date.
  • Swaps: Swaps are agreements between two parties to exchange cash flows based on specific financial variables. Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. Swaps are often used to manage interest rate risks, currency risks, or to change the nature of a debt obligation.
  • Forwards: Forwards are similar to futures contracts but are not standardized or traded on exchanges. They are customized agreements between two parties to buy or sell an asset at a specified price on a future date.