Derivatives are contracts or financial securities that derive their value from underlying entities. These underlying entities can be assets, stocks, bonds, currencies, commodities, interest rates or indexes, and are simply termed as the ‘underlying’. It is a contract between two or more parties, its price being calculated by fluctuations in the underlying asset.
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Derivatives are used for quite a few purposes like insuring against price fluctuations, or for getting access to hard-to-trade assets. Derivatives are traded over-the-counter (OTC) or on an exchange such as the New York Stock Exchange, known as exchange-traded derivatives (ETD). Other than stocks like equities or shares, and debts like mortgages and bonds, derivatives are one of the main financial instruments.
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Over-the-counter (OTC) derivatives are privately traded and do not go through an exchange or an intermediary. These derivatives are the ones that are mostly in existence. They remain unregulated and involve greater risk for the counterparty. However, exchange-traded derivatives (ETD) are regulated and standardized.
While trading goods internationally, derivatives were used to maintain balanced exchange rates because of the differing values of national currencies. Derivatives fulfilled the need for a system of accounting for these differences. In the modern times, derivatives have many more uses. Here are a few forms of derivatives.
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Forwards- Forward contracts are derivatives between two parties, where payment takes place in the future at a predetermined price decided at the time of contract. Forward contracts are non-standardized contracts and are not traded on an exchange but only over-the-counter.
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Futures- Futures are the most common types of derivatives. These are contracts to buy or sell an asset on a future date at a price been specified today. However, future contracts differ from forward contracts as they are standardized contracts. They are written by a clearing house operating an exchange where contracts can be bought and sold.
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Options- Options contracts are similar to futures, but options do not make an obligation to the buyer to make the transaction if he or she decides not to. These contracts provide the owner the right to buy or sell an asset without any obligation to do so. The exchange is optional, hence it is called options.
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Binary Options – Contracts providing the owner with an all-or-nothing profit profile are binary options.
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Warrants- Common option contracts being used are short-dated and have a maximum maturity period of one year. Warrants are option contracts that are long-dated and are traded over the counter.
Swaps- Swaps or commonly known as swaptions are contracts to exchange cash on the underlying value of currencies, exchange rates, commodities exchange, bonds or interest rates, stocks, on or before a specified future date.
Swaptions, however, are basically options on forward swaps. Swaptions are of two types, payer and receiver. One can receive fixed and pay floating in the case of a receiver swaption. In a payer swaption, one has an option to receive floating and pay fixed. Swaps are categorized in two types.
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- Currency Swaps – Currency swapping involves both principal and interest in the cash flow between two parties. The currencies are different for both parties.
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- Interest Rate Swap- The currency is the same for both parties and only interest is swapped between the two.
Derivatives are of many types but while using those in making financial decisions one must be aware of the risks associated with the derivatives like the counterparty, price and expiration, and underlying asset. It should be used only when the user or investor understands the impact of his investment and is fully aware of the risks.