What are Derivatives? How Derivatives are Traded?
A derivative is a financial contract or products that derive their value from a relationship to another underlying asset.
So essentially derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security.
The most common types of derivatives are futures contracts, forward contracts, options, swaps, and warrants are commonly used derivatives.
Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation).
Example, a stock option is a derivative because its value is "derived" from that of the underlying stock.
It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.
Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favourable interest rate relative to interest rates available from direct borrowing.
Typically, derivatives require a more advanced form of trading, including speculating, hedging, options, swaps, futures contracts, and forward contracts. When used correctly, these techniques can benefit the trader by carefully managing risk. However, there are times that the derivatives can be destructive to individual traders as well as to large financial institutions.
The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.