Derivatives are financial contracts whose value is determined by the underlying asset like a stock, bonds, currencies, commodities, and market indices. These are frequently utilized to book profit as well as to shift risk.
Dealing in Derivatives:
The underlying assets’ value fluctuates in response to various market conditions. The main idea behind getting into derivative contracts is to gain benefit by betting on the future prospects of the underlying asset. If the market price of an equity share will rise or fall influenced by a variety of elements like economic, political, and social concerns and you are aware of these developments, then you can be prepared ahead of time and gain profit or minimise your loss.
Types of Derivatives
1) Forwards
It is an agreement between two parties to buy or sell an asset, a product, or a commodity at a defined price at a future date. Forwards are traded over-the-counter and even if it does not guarantee any gains, it is largely effective for hedging and reducing risk.
2) Options
Options are financial contracts in which the buyer or seller has the option to buy or sell a security or financial asset but not the obligation to do so. Options are quite similar to futures. as it is a contract or agreement between two parties to buy or sell any form of security at a certain price in the future.
3) Futures
Futures are financial contracts that are basically identical to forwards, but can be exchanged on exchanges, resulting in standardization and regulation.
4) Swaps
Swaps are a type of financial derivative used to convert one type of cash flow into another.
Advantages of Derivatives
- There are Lower Transaction Costs
- Hedging Risks (The process of reducing risk in one’s investment by forming a new one)