Derivatives – Written by Vinny Satija

DERIVATIVES

What comes in your mind first when i say the word DERIVATIVES.? If i would have been a layman i would have thought it to be the one we studied in maths,i.e, rate of change under the topic differentiation. But it has got an entirely different meaning in finance A derivative is a financial instrument whose value is dependent upon the value of some other underlying asset.

The distinguishing feature of derivative contracts is that they are legal agreements between two parties to trade an asset at a future date. For eg, A and B made a contract in which A agreed to sell its property to B for $10 million after 6 months regardless of the market value of the property on that future date. They are in contrast to the investments in the sense that they are not issued to raise money from the investor. They are mainly issued to control future risks. They can reduce risk through a process called hedging and can even increase risk through speculation. For eg, an investor may agree to buy a share for $100 in future, so he may invest this $100 somewhere else for the time being at a risk free rate and increase it’s value but at the end of the contract he will pay only $100 for the share and will have an extra income earned on investing that $100.

There are many types of derivatives but the main ones used are-

  1. FUTURES -It is a contract between two parties to trade a standardized exchangeable asset on a set date in future at a predetermined price.
  2. OPTIONS -An option is a contract in which an investor has a right (option) to sell or buy a specified asset on the future date.
  3. SWAPS -It is a contract in which both the parties agree to exchange a series of payment according to the set formula.

This was all about derivatives. I tried to use as many examples as i could to explain this topic. I hope my motive have been achieved and i was successful is making you guys understand about this subject.

 

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