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All You Need To Know About Derivatives [2022]

anurag mendhe

Typically, the general public is familiar with stocks and the bond market. Whereas derivatives markets are somewhat less familiar to the general public.

If you’re one of them who doesn’t know “what is derivative” don’t worry after reading this post, you will not more.

In this post, you’ll look at what is derivative? how do derivatives work? What are the types of a derivative? What are their uses and benefits? And where they traded.

Despite knowing somewhat about derivatives feel free to read because you’ll learn more about it.

What are derivatives

Derivatives are financial instruments that derive their value from a benchmark or an underlying asset. Underlying is an asset in which derivatives get their value.

Derivatives are the same as other financial assets like stocks and bonds but with one exception its price is determined by another asset. Such underlying assets are stocks, bonds, commodities, currencies, interest rates, etc.

It is not necessary that underlying should be a financial instrument. Other underlying includes the interest rate, credit, electricity, or even other underlying that are not thought of as an asset.

Derivatives are a form of a legal contract between two parties, the buyer and the seller–each of whom agrees to do something for the other, now or after some time.

How do derivatives work

Derivatives are the same as insurance in which you transfer risk to the other party. In insurance, you signed a contract with an insurance company to bear risk after some event will occur.

Just like that in derivative, you signed a contract with the other party to transfer risk.

Let’s understand with an example, suppose you have a 1kilo gold worth rupees 10 lakh, and you are afraid that in six months its price might go down.

So, you signed a forward contract with the other party with a fixed price of 10 lakh and an expiration date 6 months from now when a contract is initiated. Another party is also might be thinking that gold prices will go up in the next six months.

In this contract, you’re a seller and another party is a buyer who is bearing risk.

After six months at expiration the gold price decrease to 9.5 lakh. Your prediction was correct, your transaction with the other party is an obligation so both parties settle their contract at expiration.

In this derivative contract, the buyer of the contract loses 50 thousand and you make 50 thousand of profit.

Markets of derivatives

As you might know, stocks have organized exchanges and over-the-counter markets. Same derivatives also have this both.

Exchange-traded derivatives markets

Exchange-traded has very specific terms and conditions for derivatives contracts that you can’t change. For example, specific expiration dates, limited derivatives, and fixed lot size. These specific terms and conditions create a more liquid market for derivatives.

Clearinghouses guarantee to provide the winning party its payment if the loser will default on a contract. You can trade derivatives through your brokerage account.

Over-the-counter market

It’s not standardized as an exchange rather you can make changes here consent with other parties. Any type of derivatives has legally existed in OTC. Banks are mostly dealers of these contracts.

In relative to the exchange-traded, the OTC market has a lower degree of regulation.

Types of derivatives

There is four most widely used derivative in the market forward, future, swap, and option. Although future and options are traded by most individual investors.

Forward contracts

A forward contract in which two parties the buyer and the seller trade at a future date agreed upon today’s price.

This contract is traded on the over-the-counter market. For that reason, you can make change consent with the other party.

In this, both have to obligation to settle the contract at agreeing upon a date. Because the over-the-counter market is unregulated so there are more chances to default by the other party.

Future contract

A futures contract is like a forward contract, except they trade on an exchange. It is highly regulated than a forward contract that trades on OTC.

The main benefit of a future contract is highly liquid like stocks because you can trade at any time while the market is open.

When the contract is initiated, both parties need to deposit a minimum required amount referred to as the initial margin. Typically required margin is 10% or less of the future price.

Option contract

An option is a derivative contract in which the holder agrees to pay a sum of money to the seller or writer whereby receives the right to either buy or sell an underlying asset at a fixed agreed upon today’s price.

The price at which the contract is signed is called exercise price. And the price the seller gives to the buyer to receive the right to either buy or not is called option premium.

An option has two types put option and call option. A put option gives the seller the right to either sell or not. A call option gives the buyer the right to either buy or not.

Swaps contract

A swap contract is a trade on an over-the-counter market in which two parties agree to exchange a series of cash flows.

One party agrees to pay variable series of cash flow and the other party either pay fixed or variable series determined by underlying assets.

Swaps have multiple payments, whereas forward, future and options have only a single payment at the expiration of the contract.

Conclusion

I think you’re now clear about the concepts of derivatives. If you decided to start investing in derivatives don’t just go ahead, first learn more deeply about it because this is a very complex type of investing instrument.

You’ll find more about derivatives in upcoming blogs so make sure you subscribe to the newsletter to learn more about investing.                                                                                            

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