A derivative is a financial contract that derives its value from an underlying asset. The underlying asset can be a stock, bond, commodity, currency, interest rates, or even another derivative contract (such as an index). Derivatives are typically used for hedging risk, speculating on future price movements, and gaining access to otherwise hard-to-trade assets or markets.
Purpose and Role
The primary purposes of derivatives are to hedge risk, provide leverage, and enable price speculation.
- Hedging Risk: Derivatives can be used to hedge against fluctuations in market prices. For example, a farmer might sell futures contracts for their crops. If crop prices fall, the farmer is protected because they can still sell their crops at the higher price specified in the futures contract.
- Providing Leverage: Derivatives can provide leverage, as they allow investors to potentially enjoy large returns from a small initial investment. This leverage is possible because the investor is not required to pay the full price of the asset, only a fraction of it (known as a margin).
- Price Speculation: Derivatives can be used to bet on the future price of an asset. If an investor believes the price of an asset will rise, they might buy a futures contract that allows them to purchase the asset at a lower price in the future.
The key components of a derivative contract are the underlying asset, the type of derivative (such as a futures contract, options contract, or swap), the parties involved, and the terms of the contract (including price and expiration date).
Derivatives are important financial instruments used by both individuals and institutions. They allow for the efficient transfer of risk and can help to improve market efficiency.
Derivatives have been around for centuries. One of the earliest examples is in the ancient Greek city of Thales, where contracts were drawn up for olive presses well before the harvest took place.
Benefits and Cons
- Risk Management: Derivatives allow businesses and individuals to manage their risk by locking in prices for future transactions.
- Price Discovery: Derivatives markets help in determining the prices of the underlying assets.
- Complexity: Derivatives can be complex and difficult to understand, leading to potential misuse.
- Leverage Risk: The use of leverage can amplify losses as well as gains.
A common example of a derivative is a stock option, which gives the holder the right (but not the obligation) to buy or sell a specific stock at a specific price (the strike price) on or before a specific date (the expiration date).
- Futures Contract: A type of derivative where parties agree to buy or sell a particular asset at a predetermined price at a specific future date.
- Options Contract: A derivative that gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a set price within a specific period.
- Swap: A derivative in which two parties exchange cash flows or liabilities from two different financial instruments.
- Underlying Asset: The financial instrument (e.g., stock, bond, commodity) from which a derivative's price is derived.
- Margin: The deposit required to open or maintain a derivatives position.