When it comes to investing, one term that frequently pops up is derivatives. As a layperson, you may not have a clear understanding of what it is or how it works. Well, this article aims to clear up all doubts and provide you with an understanding of the basics of derivatives.
So, what are derivatives?
A derivative is a financial instrument whose value derives from the underlying asset, such as stocks, commodities, currencies, indices, or interest rates. It provides the right to buy or sell the asset at a future date, at a specific price, which is called the strike price. Basically, it is a contract between two parties for the purchase and sale of a particular asset.
How do derivatives work?
Derivatives have no intrinsic value but instead derive their value from an underlying asset. The value of a derivative depends on the fluctuations of the underlying asset. Therefore, if the underlying asset’s price changes, the value of the derivative will also change.
Types of derivatives
There are various types of derivatives that investors can utilize. Some common types include:
1) Futures contracts – Futures contracts are agreements to purchase or sell assets at a fixed price and date in the future.
2) Options – Options are rights to buy or sell an underlying asset at a given price on or before a given date.
3) Swaps – Swaps are agreements between two parties to exchange cash flows based on a predetermined formula.
4) Forwards – Forwards are agreements between two parties to buy or sell an asset at a predetermined price at a future date.
Why are derivatives useful?
Derivatives are useful for hedging and speculation. Hedging involves using derivatives to reduce the risk of investing in specific assets. Speculation involves using derivatives to try and profit from price movements of financial assets. They can also be used for arbitrage, which involves taking advantage of price discrepancies between different markets.
Risks of derivatives.
Although derivatives can be useful, they carry risks and are not suitable for everyone. The risks associated with derivatives include market risks, credit risks, operational risks, and legal risks. The market risk is the risk of losses due to price fluctuations in the underlying asset. Credit risk is the risk of loss due to the counterparty not meeting its obligations. Operational risk is the risk of losses due to errors or failures in systems or processes. Legal risks are the risks associated with changes in legal or regulatory frameworks.
In conclusion, derivatives are financial instruments whose prices depend on the underlying assets they represent. They can be used for hedging and speculation and carry various risks. If you are considering investing in derivatives, it is crucial to understand their basics, advantages, and risks before starting. Always consult a financial advisor before making any investment decisions.