A derivative is a financial contract
that derives its value from an underlying asset. The buyer agrees to purchase
the asset on a specific date at a specific price.
Derivatives are often used for
commodities, such as oil, gasoline or gold. Another asset class is currencies,
often the U.S. dollar. There are derivatives based on stocks or bonds. Still
others use interest rates, such as the yield on the 10-year Treasury note.
The contract's seller doesn't have to
own the underlying asset. He can fulfill the contract by giving the buyer
enough money to buy the asset at the prevailing price. He can also give the
buyer another derivative contract that offsets the value of the first. This
makes derivatives much easier to trade than the asset itself.
Derivatives Trading
In 2016, 25 billion derivative contracts
were traded. Asia commanded 36 percent
of the volume, while North America traded 34 percent. Twenty percent of the
contracts were traded in Europe. These contract were worth $570 trillion in
2016. That's six times more than the economic output of the world.
More than 90 percent of the world's 500
largest companies use derivatives to lower risk. For example, a futures
contract promises delivery of raw materials at an agreed-upon price. This way
the company is protected if prices rise. Companies also write contracts to
protect themselves from changes in exchange rates and interest rates.
Derivatives make future cashflows more
predictable. They allow companies to forecast their earnings more accurately.
That predictability boosts stock prices. Businesses then need less cash on hand
to cover emergencies. They can reinvest more into their business.
Most derivatives trading is done by
hedge funds and other investors to gain more leverage.
That’s because derivatives only require
a small down payment, called “paying on margin.” Many derivatives contracts are
offset, or liquidated, by another derivative before coming to term. That means
these traders don't worry about having enough money to pay off the derivative
if the market goes against them. If they win, they cash in.
What are
Derivative Instruments?
A
derivative is an instrument whose value is derived from the value of one or
more underlying, which can be commodities, precious metals, currency, bonds,
stocks, stocks indices, etc. Four most common examples of derivative
instruments are Forwards, Futures, Options and Swaps.
A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are
1.
They
are bilateral contracts and hence exposed to counter-party risk.
2.
Each
contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
3.
The
contract price is generally not available in public domain.
4.
The
contract has to be settled by delivery of the asset on expiration date.
5.
In
case the party wishes to reverse the contract, it has to compulsorily go to the
same counter party, which being in a monopoly situation can command the price
it wants.
Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for a future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument commodity in a designated future month at a price agreed upon by the buyer and seller.To make trading possible, BSE specifies certain standardized features of the contract.
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