Expert investors often juggle between cash and derivatives markets to maximize their returns from capital market investments. A derivative is a two-party contract whose value/price is derived from an underlying asset. Futures, options, forwards, and swaps are the most prevalent types of derivatives. It offers several significant advantages over the cash market. Derivatives are usually more volatile than stocks and allow investors to hedge their market positions. Before understanding the benefits and types of derivatives, let’s learn what derivatives are.
What Are Derivatives?
The derivatives meaning refers to a form of financial contract with its value depending on an underlying asset, benchmark, or group of assets. A derivative is a contract entered into by two or more parties that can be traded on an exchange or over the counter (OTC). According to the derivative definition, these contracts are useful for trading a variety of assets and come with their own set of hazards.
Derivatives prices are influenced by movements in the underlying asset. These financial products are widely used to get access to specific markets and may be traded to mitigate risk. The derivative meaning suggests that it can help reduce risk (hedging) or to assume risk with the hope of a corresponding gain (speculation). Derivatives can shift risk from risk-averse to risk-seeking investors.
What Are The Types of Derivatives?
Although there are many types of derivatives, the following four types are the most commonly traded in the market:
A futures contract refers to an agreement between the buyer and seller of an underlying asset. The buyer decides to buy an asset at a predetermined price on the contract execution date, and the seller agrees to sell the asset on the contract execution date. Futures is an obligatory contract, meaning the buyer and seller must honour the contract.
Like futures, options refer to derivative contracts that take place between buyers and sellers. But, unlike futures, options contracts are a right and not an obligation, meaning both parties can exit the contract at any time. However, if an investor wants to exercise their rights, they can do so. The option seller is also known as the option writer, and the specified price agreed by both parties is referred to as the strike price.
Forwards are much like a futures contract. Here, the holder of the contract is obligated to honour the contract. But, unlike futures and options, forwards are not traded on stock exchanges and are unstandardised. Investors buy forwards through over-the-counter deals. Also, the buyers and sellers of forwards can customise the contract.
Like forwards, swaps are not traded through stock exchanges and happen through over-the-counter deals between financial institutions and businesses. In swaps, the cash flow depends on a notional principal amount and not real principal. Swaps generally take place in the currency segment of stock exchanges. Now that you know of the various types of derivatives, learn about the benefits of derivative trading in the following section.
Advantages and Disadvantages of Derivatives
The advantages of derivatives include the following:
● Hedging Risks
Several hedging strategies are available for reducing risk in an individual's investment by making another investment, and derivatives are the best option for it. Derivatives act as insurance policies for risk management.
● Low Transaction Cost
Trading in the derivatives market requires low transaction costs compared to shares, bonds, or other securities. Since derivatives serve as risk management tools, they guarantee low-cost transactions.
The disadvantages of derivatives are as follows:
● High Risk
Derivatives derive their value from underlying assets. Therefore, price movements in these assets can impact these contracts. The prices of underlying assets like shares and bonds have high volatility and unpredictability.
Derivatives are often used for speculation to gain profits. Due to the unpredictability of the market, speculation is highly risky and can lead to massive losses.
What Are Some Examples of Derivatives?
After knowing what are derivatives, you should know what are derivatives and their types. The different types of derivatives with examples are as follows:
Forwards are customised agreements between two parties to purchase or sell an asset, product, or commodity at a fixed price at a later date. These are not traded on central exchanges but rather over the counter, and they are not regulated to be controlled. As a result, it is largely effective for hedging and risk reduction, even though it can't offer huge profits.
Futures are quite similar to forwards. But since they cannot be traded on exchanges, they are standardised and regulated.
Options offer the buyer or seller the right to buy or sell a financial asset or security. But they are not legally obligated to go ahead with the buy or sell at the predetermined time. In case of volatility in the market, option contracts can reduce risk in the future.
Swaps are financial derivatives used for exchanging one cash flow with another. The swaps contracts are private bindings between parties and are traded over the counter.
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Derivatives might be risky, but they can help investors reduce their risk in a volatile market. To ensure low risk and high profit, you must have in-depth knowledge of what is derivatives market. So, leverage derivatives and diversify your portfolio now!
More About Derivatives Trading Basics
Frequently Asked Questions
Derivatives can lead to counterparty risks along with inherent leverage risks. Moreover, derivatives contracts can also lead to systemic risks.
Futures are a form of derivatives. Futures are considered derivatives because their value is derived from the underlying deliverable asset.
Derivatives are extremely risky, and the risk of the other party defaulting on the agreement is quite high. But derivatives are also necessary for investors to control their risk in a volatile market.