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What are derivatives?
A derivative is a kind of financial contract between two or more parties. A derivative’s value depends on an underlying asset, such as Stocks, Bonds, and other Securities. It means the price of the derivative fluctuates with the underlying asset. When an investor enters a derivative contract, they analyze the future value of the underlying asset.
Derivatives are those types of investments that involve both potential risks and significant rewards. As these contracts carry their risks, it requires performance assessment and analysis for securities you want to invest in.
Advantages and Disadvantages of Derivatives
Some of the advantages are as follows:
- Lock in prices – Derivatives help decide the price of the underlying asset because of their codependency. An analysis of derivatives can easily tell you about the price fluctuations of the asset.
- Market efficiency – It increases the market efficiency by making up for the losses that might come from the underlying assets with the practice of arbitrage. It tries to maintain equilibrium in the market.
- Hedge against unfavorable prices – One can hedge risks because of the dependency of derivative contracts’ value on the underlying assets. Sometimes, the value of a derivative contract moves in the opposite direction to the asset’s price. In such cases, the derivative profits will make up for the loss of the underlying asset.
Some of the Disadvantages of derivatives are as follows:
- Difficult to speculate – As they have associated high risk and unpredictable fluctuations, it becomes difficult to evaluate the actual value of the derivative contract.
- Counterparty risk – There is an increased risk with over-the-counter trades because of no standardization.
- High risk – Derivative contracts are prone to market risk. They Have no value of their own, and there are rapid fluctuations to the value of underlying assets like shares. These are leveraged instruments and hence involve either a huge loss or profit.
Different Types Of Derivative Contracts
There are four types of derivatives: Futures, Forwards, Swaps, and Options.
- OPTIONS – In this type of Derivative contract, an investor has an option to buy or sell the underlying asset at a specific price and on or before a predetermined future time. Although the investor has the ‘option’ to buy or sell the underlying asset, there is no obligation.
- FUTURES – Futures contracts are similar to option contracts. A Futures contract allows an investor to buy or sell an underlying asset at a specific price and a specified date. But, in this type of derivative contract, there is an obligation to buy or sell. These contracts are traded through a stock exchange.
- FORWARDS – Similar to futures contracts- both parties will get an obligation to fulfill the agreement’s end. The only difference is that forward contracts are not traded on stock exchanges. These only take place through Over-the-counter (OTC) platforms. These are not standardized because of not being done directly from the Stock Exchange and can be changed according to the investor’s requirements. There is a very high counterparty risk in this type of derivative contract.
- SWAPS – As the name goes, both parties ‘swap’ or exchange their cash flow in this derivative contract. Doing so helps in currency exchange rate risk, the default risk on loans, etc. The cash flow is based on a theoretical principle amount decided by both parties without the actual exchange of principal. The swap is generally based on the rate of interest. It is an over-the-counter (OTC) contract and is not traded on any stock exchanges. There are 3 types of swap contracts – Interest Rate Swaps, Currency Swaps (FX Swaps), and Hybrid Swaps.
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