The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks , bonds , commodities , currencies , interest rates and market indexes.
Derivatives can either be traded over-the-counter OTC or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for the counterparty than do standardized derivatives. Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With differing values of different national currencies , international traders needed a system of accounting for these differences.
Today, derivatives are based upon a wide variety of transactions and have many more uses. Because a derivative is a category of security rather than a specific kind, there are several different kinds of derivatives in existence. As such, derivatives have a variety of functions and applications as well, based on the type of derivative.
Certain kinds of derivatives can be used for hedging , or insuring against risk on an asset. Derivatives can also be used for speculation in betting on the future price of an asset or in circumventing exchange rate issues.
For example, a European investor purchasing shares of an American company off of an American exchange using U.
To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros. Futures contracts are one of the most common types of derivatives.
One would generally use a futures contract to hedge against risk during a particular period of time. Fearing that the value of her shares would decline, Diana decided that she wanted to arrange a futures contract to protect the value of her stock. The futures contract may in part be considered to be something like a bet between the two parties.
Jerry, on the other hand, has speculated poorly and lost a sizeable sum. 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 in order to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa. For this reason, he or she might seek to switch their variable interest rate loan with someone else, who has a loan with a fixed interest rate that is otherwise similar.
Yet, this can be risky, because if one party defaults or goes bankrupt , the other will be forced back into their original loan. Swaps can be made using interest rates, currencies or commodities. Options are another common form of derivative. An option is similar to a futures contract in that it is an agreement between two parties granting one the opportunity to buy or sell a security from or to the other party at a predetermined future date. An option can be short or long , as well as a call or put.
A credit derivative is yet another form of derivative. This type of derivative is a loan sold to a speculator at a discount to its true value.
Though the original lender is selling the loan at a reduced price, and will therefore see a lower return , in selling the loan the lender will regain most of the capital from the loan and can then use that money to issue a new and ideally more profitable loan.
If, for example, a lender issued a loan and subsequently had the opportunity to engage in another loan with more profitable terms, the lender might choose to sell the original loan to a speculator in order to finance the more profitable loan.
In this way, credit derivatives exchange modest returns for lower risk and greater liquidity. Another form of derivative is a mortgage-backed security , which is a broad category of derivative simply defined by the fact that the assets underlying the derivative are mortgages. As mentioned above, derivative is a broad category of security, so using derivatives in making financial decisions varies by the type of derivative in question.
Generally speaking, the key to making a sound investment is to fully understand the risks associated with the derivative, such as the counterparty, underlying asset , price and expiration.
The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a portfolio strategy. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
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