In the financial markets, derivatives trading are essential since it enables traders to increase portfolio diversification, speculate on price swings, and hedge risks. So, what exactly are derivatives?
What Are Derivatives?
A derivative is a financial instrument whose value depends on the price of an underlying asset. The underlying assets can be:
- Shares
- Bonds
- Interest rates
- Market indexes
- Currencies
- Commodities
Compared to direct investment, where one directly owns the asset, derivatives give exposure to the price movement without owning the underlying asset.
Types of Derivatives
There are several types of derivatives, viz:
- Futures – Contracts that obligate the buyer or seller to transact an asset at a predetermined price and date in the future.
- Options –Contracts that grant the buyer but not the seller, the right to purchase or sell an asset at a fixed price before on the expiration date.
- Swaps – Agreements between two parties to swap liabilities or cash flows over a set period.
- Forwards – Customised contracts between two parties to buy or sell an asset in the future at a set price.
Futures and options are traded mostly on an exchange, but swaps and forwards are traded most frequently over-the-counter (OTC) and more customised to meet individual financial needs.
Who Uses Derivatives?
Derivative trading is prevalent among most market players, including:
- Institutional investors – Hedge and mutual funds use derivatives to enhance return and mitigate risk.
- Companies – Use derivatives to hedge exchange risks and commodity price risks.
- Individuals – Consumers utilise derivatives as a mechanism of wagering where the market would go.
- Commodity traders – Exchange rates are fixed to hedge off risks arising due to highly uncertain markets.
Conclusion
Derivative trading is an advanced method of being a part of the financial markets. For speculation or hedging purposes, these derivatives are an essential part of today’s world economy. However, for trading successfully, one needs to know the return as well as the risks.
