What are Derivatives and their types?

Summary:

The term derivative is closely related to the world of finance; it can be interpreted as a financial contract between two or more parties that aims to fulfill an agreement to sell or purchase certain assets or commodities.

In finance, there are many important terms that we still need to understand. Such is the case with derivative terms. This term refers to the form of a financial instrument.

A derivative is a financial instrument whose price or value depends on the importance of other assets or instruments present in the market. These are called “underlying assets” and can have different shapes and characteristics: government bonds, gold, equity derivatives, oil, and other commodities and assets.

Why do investors opt for derivatives?

It should be emphasized from the outset that derivative investments are not a “classic” investment choice, but three strategies can lead an investor to focus on these assets.

To protect against the risks of an investment already made: in this case, a derivative product can compensate for a potential loss due to an unfavorable market situation.

To speculate: Derivatives are volatile assets with high financial leverage. In short, you can gain a lot but also lose a lot in a short time. Therefore, experienced speculators use equity derivatives to profit from the underlying asset’s performance, but the risk of loss is high.

Arbitrage involves buying or selling an underlying security and simultaneously doing the opposite operation with the derivative listed on a different market to make money by taking advantage of price differences.

The main derivative instruments

There are a considerable number of derivatives (regulated or not) on the markets, classified into four distinct categories:

Forward Contract: This is a fixed-term buy-sell contract traded over the counter (OTC) on unregulated markets. The buyer undertakes, through these contracts, to buy the underlying asset at an agreed price on a predetermined future date. The seller also undertakes to respect the agreement, even if the future sale should lead to a negative result.

An exchange contract (swap) is an exchange with all effects (to swap = to exchange). It allows the two parties to exchange cash flows at a future date previously determined based on the value of the chosen underlying.

, Banks and companies often use this instrument and even public bodies to protect themselves against investment risks. Typically, interest rates, currencies, commodities, and stocks are traded.

Futures contract: this instrument is used in regulated markets. It is like over-the-counter forward contracts in that it provides for the exchange of a fixed amount of the underlying asset at a previously determined future date and at a price already decided.

Options: in this case, the buyer acquires from the seller the possibility of buying or selling, within a specified period, a certain quantity of the underlying asset at the agreed price.

Simply put, derivatives are financial products in which there is an agreement between two or more that aims to sell or buy products at a price, time, and amount that has been mutually agreed upon beforehand.

This instrument has several types that you can adjust to your needs and financial conditions, for example, stock derivatives. This instrument has also been protected and has a legal basis to support its implementation. However, as with other types of devices, you need to understand how this instrument works and the possible risks.