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The basics of derivatives

July 30th, 2011

A Security whose price is dependent or derived from one or more underlying assets is called a derivative. Very simply put it is a contract between two or more parties. The value of a derivative is determined by fluctuations in the underlying asset. These underlying assets include stocks, bonds, currencies, commodities, stock market indexes and interest rates.

A small movement in the value of the underlying asset can cause a large difference in the value of the derivative. It is because of this property that derivatives can provide leverage to an investor.

Derivatives are mostly used as a means to hedge risk. Hedging is a technique that attempts to decrease risk. Derivatives can thus be considered as a form of insurance.

Derivatives allow risk with regards to the price of the underlying asset to be shifted from one party to another. Therefore when two parties enter into a contract, one party is the insurer for one type of risk, and the counter-party is the insurer for another type of risk.

Hedging can also occur when an individual or institution buys a commodity or a stock that pays dividends and sells it using a ‘futures contract”. The individual or institution will then have access to the asset for a specified amount of time, and can sell it in the future at a specified price according to the futures contract.

Derivatives can also be used to take risk rather than to hedge risk. An investor can enter into a futures contract to deliberate the value of the underlying asset. He will then bet on whether the party seeking insurance will be wrong about the value of the asset in the future.

In this way a speculator can buy an asset for a low price in the future when its market price is high. Similarly the speculator can sell an asset for a high price when the future market price is low. This buying and selling of risk is considered to have a positive impact on the economic system.

Futures contracts, options and swaps are the common forms of derivatives contracts. A futures contract is a contract between two or more parties to trade a certain asset at a specified date in the future at the price agreed on today. Swaps are contracts to exchange cash on or before a certain future date. Cash is exchanged based on the underlying value of commodities, stocks, exchange rates or other such assets

Options give the owner the right but not the restraint to buy or sell an asset. The sale takes place at a certain price called the strike price. This price is specified when the parties enter into the contract. This contract will also specify a maturity date.

There are five major classes of underlying assets. These are interest rate derivatives, foreign exchange derivatives, credit , equity and commodity derivatives.

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