Derivates are the financial instruments used for differentiating risks. These are allocated to the investors who are able to take it for generating higher profits. Derivates are the contracts for minimizing risks involved in an investment.
The investor makes different types of investment for earning higher returns and minimization of future risks. Derivatives are the result of expansion of the financial market instruments. In mathematics, derivative means a variable which has no value of its own and is derived from another variable. On the similar parlance, in finance, derivatives have not value but they derive value from other underlying assets. Thus, the price of the underlying asset is important for determining the value of the derivative.
Let us take an example. The derivative of the underlying shares of a company will acquire its value from the value of the same company. In the similar way, the derivative of soybean is dependent on the soybean price.
Feature of Derivatives
The first characteristic of derivatives is that it is specialized contract. It contains an agreement of buying or selling the underlying asset with a certain time limit in future and at a predetermined price. The tenure of the derivative contract is also fixed and generally, between 3 to 12 months. The value of derivatives depends on the price of the underlying asset and also on the expiry period of the contract itself.
Derivative Contracts
If the derivative contracts are traded on a stock exchange and are in standardized form, then these are known as exchange-traded derivatives. These derivatives are having benefits such as less transaction expenses and no risk from the default party involved. Some derivatives can also be tailored according to the requirements of the users. This is possible by negotiating with the parties involved in the contract. These types of derivatives are known as over-the-counter derivatives.
Forms of Derivatives
The four forms of derivatives are forwards, futures, options & swaps.
Future contracts provide the concerned user with the opportunity of buying and selling of underlying are established at a price and date beforehand. They have fixed components such as expiry period, size and price.
Forwards can be customized according to the size of contract, expiry period, and price and depends on the user preferences.
Options provide an option to the holder of buying or selling of the underlying at a pre-determined price in future. These are further divided into call option and put option.
Conclusively, derivatives are strong with respect to risk management. It has definitely redefined the concept of financial instruments and industry. But derivatives can also be risky and complex to understand. Derivatives can be perceived as an instrument for investors, attached with returns and risks. Before trading in derivative market, you must understand the basic concepts and accept the risks involved in it.
