What are derivatives?
Derivatives are financial instruments that get their value from one or more underlying assets, such as commodities, stocks, bonds, interest rates, or currencies.
The derivative itself is a contract between two parties, which specifies the conditions under which a transaction is to be made.
Derivatives can be used to hedge the risk of unexpected price changes, or in speculative trading.
Almost all derivatives have a finite lifespan. At some time, the investor must fulfill the terms of the derivative and buy or sell the underlying asset, or allow the derivative to expire.
The main types of derivatives include the following:
- future contracts
- forward contracts
Hedging is a strategy used to reduce the risk of unfavorable price changes.
Investors hedge their investments when they are uncertain about the direction of the market and want to protect their assets against adverse price movements.
A hedge usually involves taking an offsetting position, such as entering into an agreement with another party to sell or buy an asset at a predetermined price to prevent loss.
|Joe is a soybean farmer. He wants to ensure that he can sell his crop at a particular price to cover all his costs and to allow him to make a profit. Instead of waiting until he harvests his crop, Joe enters into a derivative contract now to sell his crop at a specified price on a specified date. By entering the contract, Joe guarantees the price he will receive for his crop.|
Speculation is a strategy intended to increase profit. It involves executing very high-risk financial transactions that have the potential of providing high returns.
Trading on the basis of speculation is called speculative trading. This strategy is the opposite of a buy-and-hold strategy, where someone invests in an investment for a long period with the objective of gaining a long-term return. Speculative trading involves buying and selling an asset to make a substantial gain in a short period.
Someone who engages in speculative trading is called a speculator.
Options are derivative contracts that give an investor the right to buy or sell a pre-determined amount of an underlying security at a set price for a set period of time. There are two parties involved in an option transaction: the option buyer and the option seller. The option buyer, also known as the holder, has the right to buy or sell the underlying security. The option seller, also known as the writer, has the obligation to buy or sell the underlying security if the buyer decides to exercise the option. The option buyer must pay the option seller a price for this right, called a premium.
There are options on many different securities, such as stocks, bonds, and indexes, but the most common are stock options.
There are two types of options:
- Call options allow the option buyer the right to buy an underlying security at a pre-determined price. They are used when an investor believes the security price will go up in the future.
- Put options allow the option buyer the right to sell an underlying security at a pre-determined price. They are used when an investor believes the security price will fall in the future.
Futures contracts are intended to solve the basic business risk of future price uncertainty. With futures contracts, investors can control as much of the future as possible, in that the contract can set a pre-determined price for a good that is to be delivered at a specific time in the future.
Futures contracts differ from options because there is a legal obligation to buy or sell the underlying asset.
The futures market is where producers and users of commodities such as wheat, meats, currency, interest rates, and securities buy and sell contracts. Note that the definition of commodities has been expanded from physical goods to include financial assets.
Buyers of futures are considered to be “long” on the commodity, meaning the commodity will belong to the buyer at a defined time for a specific price. Whereas the seller is said to be “short” on the commodity because they agree to deliver the commodity at a pre-determined price and date and will be short of the commodity after its delivery.
A forward contract is an agreement that allows a buyer to purchase an underlying asset such as stocks, bonds, or currency, from a seller for a pre-set price at a specific future date. The provisions of the contract, including the price and sale date, are customized by the seller and buyer.
Forward contracts are similar to futures contracts because there is a legal obligation to buy or sell the underlying asset.
Differences Between Forward and Futures Contracts
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