A derivative is a kind of financial instrument which is derived from some other underlying assets. Trading using derivatives has been emerging and many countries follow this method. Here, instead of trading or exchanging the asset involved, traders can have agreement among themselves for exchanging either cash or assets.
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A good example of this kind is a future contract. Here the traders will involve in an agreement that in a future date they both agree to exchange the underlying asset. Derivatives usually have high leverage because even a small change in the asset value can cause high difference in the derivative.
Derivatives are used by investors mainly for speculating and making profit in the financial market. But, this will work only if the value of the asset follows the trend in the financial market as expected. If the asset price moves in a downward direction in the financial market then it could prove risky. In such cases where traders are uncertain of the assert price trend they can use hedge or can enter into agreement for which the opposite derivative moves in opposite direction.
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In the financial market, derivatives classified based on the following:
- The link between the derivative and the underlying asset.
- The kind of the underlying asset. This can be equity derivatives, interest rate derivatives foreign exchange derivatives and credit derivatives.
- The type of market where the trade happens. It can be traded over the counter or using exchanges.
Hedging:
This technique reduces the risk involved in financial market. In this method, the risk involved in the derivative can be transferred from one trader to the other. For example consider a derivative agreement between a wheat farmer and a miller. They can sign for an agreement so that the wheat farmer can hand over a certain amount of wheat to the miller and the miller in turn gives a certain amount of cash.
The money involved and the quantity of the asset involved can be stated in the agreement. Wheat farmer satisfies with the fact that he has got a customer to sell his product for a confirmed amount. He cannot predict the price of the wheat in future.
So, the risk involved is reduced to a huge level. The miller satisfies with the fact that he has got wheat supply in future. Both the farmer and the miller have reduced the risk factor involved, the farmer with the price and the miller with the wheat supply.
Types of derivatives:
In the present financial market condition, derivatives can prove to be a method of acquiring risks. There are two types of derivatives existing in the financial market – Over the counter derivatives and exchange traded derivatives.
Over the counter derivatives are largest among the derivatives. Here the trading happens directly between the parties involved. There will be no intermediates involved. In exchange traded derivatives, contracts are signed and trading happens through some specialized exchanges.
