Layman's Explanation of Derivative in the Financial Market
What are Derivatives?
Derivatives refer to financial instruments whose value is derived from the value of an underlying asset, index, or rate. Derivatives are contracts between two parties that derive their value from changes in the price of the underlying asset.
Purpose of Derivatives
Derivatives are used for various purposes in financial markets, and their popularity is driven by the flexibility they offer to market participants. Here are some common reasons why derivatives are used:
- Risk Management:
- Hedging: Derivatives are frequently used to hedge against price fluctuations in the underlying asset. Businesses and investors use derivatives to protect themselves from adverse movements in interest rates, commodity prices, currency exchange rates, and more.
- Portfolio Diversification: Derivatives can be employed to diversify investment portfolios and manage overall portfolio risk.
2. Speculation:
- Leveraged Trading: Derivatives allow investors to control a larger position with a relatively small amount of capital. This leverage magnifies both gains and losses, making derivatives attractive for speculative trading strategies.
- Price Movements: Traders use derivatives to speculate on the future direction of prices, whether it be in stocks, commodities, currencies, or other underlying assets.
3. Arbitrage: Traders may use derivatives for arbitrage opportunities, exploiting price discrepancies between related assets or markets to make a risk-free profit.
Types of derivatives:
- Options:
- Call Option: This gives the holder the right (but not the obligation) to buy a specific quantity of the underlying asset at a predetermined price within a specified timeframe.
- Put Option: This gives the holder the right (but not the obligation) to sell a specific quantity of the underlying asset at a predetermined price within a specified timeframe.
Options trading allows investors to speculate on price movements, hedge against potential losses, or generate income through writing options.
2. Futures:
- Futures contracts obligate the buyer to purchase, or the seller to sell, a specific quantity of the underlying asset at an agreed-upon price on a future date.
- Futures are often used for hedging against price fluctuations, especially by participants in commodities markets.
3. Forwards:
- Forward Contracts: Similar to futures contracts, but typically customized agreements traded over-the-counter (OTC) between two parties.
