What are Derivatives
Derivatives are a type of contract between two or more parties whose value is based on an underlying financial asset. The underlying assets can be stocks, bonds, indices, currencies or commodities like gold, silver, oil, natural gas and many more.
Derivatives where created to manage the risk which is associated with the underlying asset. They can be used as speculating tool (high risk high reward) or Hedging (mitigating risk). There are three types of market participants in a derivatives scenario,
1. Hedger: A person who uses derivative instrument to reduce the risk in volatility of price changes in the underlying asset.
2. Speculators: They are willing to bear the risk and have a high-risk profile in order to obtain high rewards.
3. Arbitrageurs: They simultaneously enter into two or more markets to take an advantage of discrepancies between asset prices in those markets. Their margins are very low compared to other participants.
There are 4 broad type of derivative instruments: Forwards (OTC), Futures (Standardised), Options and Swaps.
Forwards – A forward contract is a customizable derivative contract between two parties to buy or sell an asset at a specific price on a specific future date. They do not trade on centralised exchanges and thus classified as Over-the-Counter (OTC) instruments.
Futures – A futures contract is a legally-binding agreement to buy or sell a standardised asset on a specific date or during a specific month. It is facilitated through an exchange and the contracts are standardised.
Options – An option contract is an agreement between two parties to facilitate a potential transaction to buy or sell an asset at a predetermined price on a predetermined future date. Buying an option offers the right, but not the obligation to purchase or sell the underlying asset.