A derivative is a financial instrument whose value is derived from the value of an underlying asset, index, or rate. A derivative can never be an independent financial instrument; its value depends on the variation in the price of the underlying asset. Stocks, bonds, commodities, interest rates, and currencies are common underlying assets.
Types of Derivatives
- Forward Contracts: Free contracts to sell or buy an asset on a specific future date at a pre-agreed price.
- Futures Contracts: Exchange-traded contracts that compel one to buy or sell in the future on a given date and price.
- Options: Contracts that give one the right but not the obligation to sell or buy the underlying asset at a pre-agreed price before a pre-agreed date.
- Swaps: Two-way bilateral contracts for exchanging cash flows, typically on an interest or currency basis.
Application of Derivatives
- Hedging: Investors use derivatives to hedge against future price changes in the underlying instrument.
- Speculation: Speculators use derivatives as a vehicle to make a profit from price changes in the underlying instrument.
- Arbitrage: Taking advantage of mispriced assets in or between different instruments or markets with the intention of making a riskless profit.
Conclusion
Derivatives are a powerful tool of contemporary finance, serving as tools for price discovery, speculation, and hedging. Owing to their complexity and the capacity to incur very large losses, however, they are generally suited for sophisticated investors and institutions. Proper regulation is essential to harness the benefits from their value and hedging potential.
