Meaning of Derivative
Derivatives are financial instruments that derive their value from the value of one or more underlying assets. For example, some of the assets are stocks of companies, bonds, and debentures of companies, currencies, etc. The value of assets upon which derivative instruments are based keeps changing as per the conditions prevailing in the market. Derivatives are used to make profits by speculating the value of underlying assets.
For example, you have invested in equity shares and the value of equity share can go up and down. In case there is a downfall in the value of equity share then you may be a loss. To cover this loss you have an option to enter in a derivative contract and make gains if you have an accurate bet. Or you can hedge your position by entering into a derivate contract.
2. Why do investors enter derivative contracts?
Though derivatives are used to make profits, there are also various reasons for entering into derivative contracts, here are some of the reasons as follows.
- To carry out Arbitrage Activity
Arbitrage is an activity by which one may make profits from buying a commodity in one market at a low price and selling the same in another market at a high price. In this way, there is a profit from the differences in buying and selling prices.
- Protection from volatility in the market
The nature of the stock market is volatile i.e prices of the stocks and commodities are fluctuating day by day. Therefore there are very much chances of losses by a decrease in the value of the stock. In such a situation, derivative products are used as a shield against such losses. Similarly, you can use derivative products as a safeguard mechanism against the rise in the price of a stock that you are willing to buy.
- Park surplus funds
Some persons use derivatives instruments as a means of transfer of risk. However, some persons use derivatives for speculation and making profits. Also, you can use derivatives contracts in profit-making by using price fluctuation without selling the underlying assets.
3. Types Of Derivative Contracts?
Mainly there are four major categories of derivative contracts viz. options, futures, forwards, and swaps.
Options are contracts under which one gives the right to the buyer of the option to buy or sell of an underlying asset at the price specified in the contract and during a certain period. The buyer of the option has a right but not an obligation to exercise the option at the agreed price. The price agreed under the contract is called the strike price. Options are two types one is an American option and another is a European option. American options can be exercised before the date of expiry but European options can only be exercised at the date of expiration only.
- Future contracts
Future contracts are derivative contracts whereby holder of the futures contract has to buy or sell the asset at price agreed in the contract at the date specified in the contract. Both the parties in the futures contract has the obligation to perform on the date of expiry. These are traded on stock exchange and the value marked to market on a daily basis, this means any increase or decrease in the value of underlying asset is adjusted every day till the date of expiration.
- Forward Contracts
Forward contracts are similar to that of future contracts whereby the holder of the futures contract has the obligation to perform the contract. But there are some differences from future contracts such as these contracts are not traded over stock exchange but are traded over the counter and can also be customized as per the needs of the parties to contract. These contracts are not marked to market as these are not traded over the stock exchange.
Swaps are types of derivative contracts where two parties enter into the contract and exchange their financial obligations. Under this contract, a notional principal amount is agreed between the parties to contract. The net cash flow in the contract is based on such a notional principal amount and is calculated using a rate of interest. There are two types of interest rate one is fixed rate and the other is fluctuating rate which is based on a benchmark interest rate. The most commonly used swaps are interest rate swaps. Swaps are over the counter products and not traded over stock exchanges.
Also Read: What Is Repo Rate? What Is Reverse Repo?