Derivatives are financial instruments which derives its value from an underlying asset. The underlying assets can be currency, gold, stock or any commodity. In other words derivative is not an asset but a contract or an agreement between two or more parties to transfer a real asset in future. The price and date of execution are mentioned in the contract.There are various types of derivatives among those the most common ones are forward contracts, Futures contracts, swaps and options. There are some derivatives which are based on weather information such as number of sunny days or the amount of rainfall in a particular area. Some of the important key words which will help to understand derivatives:
Holder: The buyer of a derivative agreement is called the holder of the derivative.
Seller: the person who sells the contract to the holder.
Expiry Date: The date on which the agreement/contract will get matured.
Strike price: The price at which the derivative will be exercised. This price is decided by the buyer and seller at the time of agreement.
In general derivatives are used as an instrument in order to hedge risk but they can also be used for speculation. These derivatives have a theoretical face value and its values can be determined by using black scholes pricing model formulas and other models. These derivatives are frequently traded as assets in the open markets and have a specified expiry date. In forex markets especially derivatives allow investors to earn good return from the movements of underlying asset’s price. They can also lose big amounts if the prices move against it.
“Bell the bull says Derivatives are instruments to bring protection against unexpected price rise or fall of an underlying asset. Moreover, derivatives help in yielding good returns with lower investment”.