Derivatives are one of the most popular types of investments in the modern investment market. There are many financial instruments in the modern investment market such as mutual funds, treasury bills, treasury bonds, and various types of deposits. A derivative can be identified as a contract between two or more parties whose value is decided based on an underlying financial asset or set of multiple assets. These are complex financial instruments that are generally used for various purposes such as accessing additional assets, accessing additional markets, and hedging.
The most commonly identified derivatives are stocks, bonds, market indexes, options forwards, swaps, futures, and warrants. Derivatives are considered secondary securities and the value of the securities is only derived from the value of the underlying security.
Most derivatives are traded over-the-counter (OTC). However, in some instances, derivatives such as futures, options, and contracts are traded on specialized exchanges due to specific reasons. Generally, investing in derivatives is considered advanced investing.
Derivative products can be divided into two categories.
Lock products – These are derivatives that attach the respective parties from the start to the agreed-upon terms over the lifetime of the contract.
Eg: futures, forwards, swaps
Options Products – These are derivatives that offer the right to the holder, but not the obligation, to purchase or sell the underlying security or the asset for a specific price before the maturity date.
Even though the value of a derivative is based on an asset in the investment market, ownership of a derivative does not imply the ownership of the asset.
Types of Derivatives
01. Futures Contracts
Futures Contracts are a type of derivative in which the value is affected by the performance of the underlying asset. It is an agreement to buy or sell a security or a commodity at a predetermined price and at a pre-specified date in the future. Futures contracts contain a specified quantity and an expiration date. It can be used with commodities such as precious metals, oil, and wheat.
Options can be identified as a contract that gives the right to the buyer of the contract, but not the obligation to buy or sell the derivative at a predetermined price. Based on the type of option, the buyer has the ability to exercise the option. For European options, the buyer can exercise the option on the maturity date and for American options, the buyer can exercise the option on any day before the maturity.
Swaps are a type of derivative that allows the exchange of cash flows between the two involved parties. Generally, swaps are involved with exchanging a fixed cash flow for a floating cash flow. Interest rate swaps, currency swaps, and commodity swaps are the most common types of swaps in the investment market.
04. Forward Contracts
A forward contract is a derivative where the buyer agrees to purchase the underlying asset from the person who is selling at an agreed specific price on a specific date. These types of contracts have the ability to customize more than future contracts and can be customized based on the commodity type, amount, and date.