Derivative securities are financial contracts whose value is derived from an underlying asset or group of assets. They are called “derivatives” because their value is derived from the value of something else. Examples of underlying assets include stocks, bonds, commodities, currencies, and interest rates.
There are several types of derivative securities, including options, futures, forwards, and swaps. Each type has its own unique characteristics and uses.
- Options: An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) and time in the future. There are two types of options: call options and put options. Call options give the holder the right to buy the underlying asset, while put options give the holder the right to sell the underlying asset.
- Futures: A futures contract is an agreement to buy or sell an underlying asset at a specified price and time in the future. Futures contracts are standardized and traded on exchanges. They are commonly used by producers and consumers of commodities to hedge against price fluctuations.
- Forwards: A forward contract is similar to a futures contract, but it is not traded on an exchange. Instead, it is a customized agreement between two parties to buy or sell an underlying asset at a specified price and time in the future.
- Swaps: A swap is an agreement between two parties to exchange cash flows based on different financial instruments. The most common types of swaps are interest rate swaps and currency swaps. Interest rate swaps involve exchanging fixed and floating interest rate payments, while currency swaps involve exchanging payments in different currencies.
Derivatives can be used for a variety of purposes, such as hedging against risk, speculating on price movements, and creating synthetic exposures to certain assets. However, they can also be complex and carry significant risks, such as leverage, counterparty risk, and market risk. It is important for investors to understand the risks and potential rewards of derivative securities before investing in them.