Derivatives are a type of security. Their value is dependent, or derived, from the value of underlying assets. These underlying assets could be stocks, bonds, commodities, currencies, interest rates, or market indexes. The value of the derivative will fluctuate according to the value of the underlying assets. However, derivatives are a broad investment category and there are several types. These include futures, forward contracts, swaps, mortgage-backed securities, and options. In this article, we will briefly go over each of these derivatives and how they work.
Futures are contracts. They can be agreements between two parties for the sale or purchase of an asset at an agreed-upon price at a future date. It can be based on a physical commodity or a financial instrument. The contract will detail the quantity of the assets, the price, and the future contract execution date. The parties must fulfil the contract on the set date, there is no choice of exercise like there is with options. When the contract is settled there may be the delivery of a physical asset or just an exchange of cash. These contracts are very standard and trade on exchanges.
Forward contracts are custom contracts between two parties. This contract obligates them to sell or buy an asset at a specific price on a set future date. They can be settled either with cash or delivery of an asset. They are highly customizable, for this reason, they trade over-the-counter instead of on an exchange.
A swap is when two parties exchange financial instruments. These are over-the-counter trades, typically done by large companies or financial institutions. Usually, institutions and companies utilize swaps to reduce the risk of issuing bonds. They act as a type of insurance in the instance that a buyer defaults.
A mortgage-backed security is a type of derivative that is secured by a mortgage or a collection of mortgages. There are two main types of mortgage-backed securities: pass through and collateralized mortgage obligations. Pass-throughs are trusts. This trust collects the mortgage payments and the proceeds to pass through to the investors. Collateralized mortgage obligations create multiple pools of securities, called tranches. Each tranche has a set credit rating and interest rate. The investor’s proceeds are the interest they earn off the tranches.
Lastly, an option is a contract between two parties. It gives you the right to buy or sell the underlying stock at a set price, before a set date. These are very similar to futures, except they are optional. You can choose to exercise it or to let it expire worthless.
Derivatives can be powerful tools to help experience investors diversify their portfolios. However, they do come with great risk and the information in this article is a very basic overview. Before you decide to invest in any type of derivative it is important that you consult with an experienced professional.
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