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In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and can include any sort of financial instrument. Derivatives are secondary securities whose value is solely based (derived) on the value of the primary security that they are linked to.

Key Features of Derivatives

  • Leverage: Derivatives often allow significant leverage, meaning that they can provide large exposures with a relatively small amount of invested capital.
  • Contracts: They are contractual agreements with terms defined by the parties involved.
  • Expiry: Most derivatives have an expiration date, at which point their value is settled between the parties.

Types of Derivatives

  1. Futures: Contracts to buy or sell an asset at a future date at a price agreed upon today. Commonly traded on exchanges, making them standardized and regulated.
  2. Options: Contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a set price on or before a given date.
  3. Forwards: Customized contracts between two parties, where settlement takes place on a specific date in the future at today’s pre-agreed price.
  4. Swaps: Contracts to exchange cash flows or other financial instruments between two parties at set times in the future.

How Derivatives Are Used

  • Hedging Risks: Derivatives are used to hedge against risks such as movements in stock prices, interest rates, or currencies. For example, an importer expecting to pay for goods when they arrive in the future can use a foreign exchange forward to lock in the price they will pay in their home currency.
  • Speculation: Traders use derivatives to speculate on the future direction of an underlying asset’s price. For example, buying options on stocks can leverage an anticipated price change.
  • Arbitrage Opportunities: Traders can also use derivatives to take advantage of price discrepancies between different markets or forms. For example, if the future price of an asset is misaligned with its expected future price derived from the current spot price, a trader might buy the asset in one market and sell it in another to profit from the difference.
  • Access to Otherwise Inaccessible Markets or Assets: Some derivatives offer exposure to markets or assets that may be out of reach for most traders due to regulatory, geographical, or other constraints.

Examples of Derivatives

  • Stock Options: An investor believes that the stock price of Company XYZ will go up in the next three months. They can purchase a call option giving them the right to buy the stock at today’s price within the next three months. If the stock’s price goes up, they can exercise the option and buy the stock at the lower price, immediately realizing a gain.
  • Interest Rate Swaps: A company with a variable interest rate loan might be concerned about rising interest rates. To manage this risk, they enter into an interest rate swap with another firm to exchange their variable rate loan payments for fixed-rate payments, thus locking in their future costs.
  • Currency Futures: A U.S. company that expects to receive payments in euros may use currency futures to lock in the exchange rate at which the euros will be converted into dollars, protecting themselves against a potential weakening of the euro against the dollar.

Derivatives are a critical tool in modern finance that offer versatile strategies for hedging, trading, and increasing market efficiency.