What are derivatives?
Derivatives are financial instruments whose value is derived from the performance of an underlying asset, index, or rate. Common underlying assets include stocks, bonds, commodities, currencies, and interest rates. Derivatives can be used for various purposes, including speculation, hedging, and arbitrage.
There are several types of derivatives, with the most common being:
Futures Contracts: Agreements to buy or sell an asset at a predetermined price at a specific date in the future. Futures are standardized and traded on exchanges, making them highly liquid.
Options Contracts: These give the holder the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a predetermined price before or at expiration. Options can be used strategically to manage risk or speculate on price movements.
Swaps: Contracts in which two parties exchange cash flows or other financial instruments. The most common types are interest rate swaps and currency swaps, used primarily to manage exposure to fluctuations in interest rates or currency exchange rates.
Forwards: Similar to futures, forward contracts are agreements to buy or sell an asset at a specified future date for a price agreed upon today. Unlike futures, forwards are customizable and traded over-the-counter (OTC).
Derivatives can introduce both opportunities and risks. They can amplify returns by allowing investors to take larger positions relative to their initial investment. However, they can also lead to significant losses if the market moves unfavourably. Proper risk management and a deep understanding of the underlying assets are crucial when engaging in derivative trading.