Derivative Basics

A derivative is a financial contract. Its value is contingent on an underlying asset or group of assets. The price of a derivative will fluctuate with the value of the underlying asset. The underlying assets can include stocks, bonds, commodities, currencies, interest rates, and market indexes. They are often used to hedge against risk. Hedging is a way to minimize risk by protecting your profits from being eliminated due to changes in the market. In this article, we are going to go over the different types of derivatives available to you.

Locks and Options

There are two main classes of derivatives, lock and options. Locks are binding contracts that keep the parties subject to the agreed upon terms for the life of said contract. These include futures, forwards, and swaps. Options give the holder more flexibility. Stock options allow you to buy or sell the underlying assets at a specific price before the expiration date.

Futures

A future is a contract agreement between two parties. They agree on the purchase and delivery of an underlying asset at an agreed upon price at a set future date. Futures are standards products that trade on an exchange.

Forwards

Forwards are similar to futures. But you are able to customize the terms, size, and settlement process. These do not trade on an exchange.

Swaps

You can use a swap to exchange one kind of cash flow with another. For example, you can use an interest rate swap to switch from a variable interest rate to a fixed interest rate loan or vice versa.

Options

An option is a type of derivative that is an agreement between two parties to buy or sell an asset at a specified future date for a predetermined price. However, the buyer is under no obligation to exercise this option.

Advantages and Disadvantages

As with all financial products, derivatives come both with advantages and disadvantages. Some of the advantages include the ability to secure pricing, hedge against unfavorable movements in the market, and mitigate risk. These advantages typically come at a relatively low cost. Some of the disadvantages include being difficult to value, it has no intrinsic value, and it is vulnerable to market changes.

Utilizing Derivatives

Derivatives can help to diversify your portfolio. However, these are complex vehicles. You should only utilize them with the help of a qualified professional.

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