Derivatives

By: EconomyWatch Content   Date: 8 February 2010

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 Derivatives are financial instruments, the price or value of which is derived from some other asset, index, value or condition known as underlying assets. Derivative trade does not involve actual trade in the underlying asset but an agreement to exchange cash or assets over time based on the underlying asset. Most derivatives carry high leverage meaning that a small change in the underlying assets results in a large change in the value of the derivative. 

Types of Derivatives

Derivatives can be categorized on the basis of:

ü      The relationship between the derivative and underlying assets into categories such as futures, options and swap

ü      The type of the underlying asset into categories such as equity derivatives, credit derivatives, interest rate derivatives, foreign exchange derivatives

ü      The market in which they trade into categories such as over the counter and exchange traded

Over the counter derivatives are contracts that are privately negotiated and traded between two parties directly. Swaps, forward rate agreements and exotic options are the examples of OTC derivatives. In contrast, exchange traded derivatives are traded on an exchange which acts as an intermediary and takes initial margin from both the parties. Index futures and options and interest rate related products are generally traded on derivatives exchanges.

Futures and forwards are contracts to buy or sell an asset before a future date at a price specified today. While futures contracts are standardized, forwards are not. Options are contracts that give the owner the right (but not the obligation) to buy or sell an asset before a future date. Swaps are contracts to exchange cash flows before a future date which is specified in advance based on the underlying value of currencies, commodities or other assets. A combination of the elements of the above type of derivatives is used to develop complex derivatives. 

Purpose and Risk of Derivatives

Derivatives are used by investors to speculate and earn some profits if the value of the underlying assets moves in the direction perceived by them. Similarly, traders use derivatives to mitigate or hedge the risk in underlying assets by entering into a derivative contract whose value moves in the opposite direction to their underlying position.

The use of derivatives can result in large losses if the value of the underlying asset declines or moves in the opposite direction and counter party risk in case of private agreements.


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