Derivatives from the name it is a set of financial instruments that their value are based on an underlying asset or groups of assets which are commodities, currencies, bonds, interest rates, market indexes and stocks etc. The use of derivatives to hedge risk and improve returns has been around for generations, particularly in the farming industry, where one party to a contract agrees to sell goods or livestock to a counter-party who agrees to buy those goods or livestock at a specific price on a specific date. This contractual approach was revolutionary when first introduced, replacing the simple handshake. Trading derivatives can be done in two ways which could either Over The Counter (OTC) or in an exchange.
Derivatives despite how numerous they are they can be grouped in three forms which are:
- Options or Forward Contracts
Options these are another common form of derivative. An option is an agreement between two parties granting one the opportunity to buy or sell a security from or to the other party at a particular future date. The key difference between options and futures is that with an option, the buyer is not obligated to make the transaction if he or she decides not to, hence the name “option.” The exchange itself is, ultimately, optional. Like with futures, options may be used to hedge the seller’s stock against a price drop and to provide the buyer with an opportunity for financial gain through speculation. An option can be short or long, as well as a call or put.
Swaps are another common type of derivative. A swap is most often a contract between two parties agreeing to trade loan terms. “One might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa” (Investopedia). If someone with a variable interest rate loan were trying to secure additional financing, a lender might deny him a loan because of the uncertain future bearing of the variable interest rates upon the individual’s ability to repay debts, perhaps fearing that the individual will default.
Futures Contracts are agreements made on the trading floor of a futures exchange between two parties to buy or sell an asset (commodity or financial instrument) at a certain time in the future at a certain price. The future contract is a way investors or manufacturers use in hedging against fluctuations in prices especially commodities. For example if a producer of corn flakes and a farmer goes into a contract that by February 2019 the farmer will supply 5000 bushels to the producer at $9.50 per bushel. In this contract one person will definitely gain and the other will lose depending on the direction of the price by the agreed date.