Derivatives are financial instruments that derive their value from an underlying asset or group of assets. Here are the most common types of derivatives with brief explanations and illustrations:
1. Futures Contracts: Futures contracts are agreements between two parties to buy or sell an asset at a specific price on a specific future date. Futures contracts are traded on organized exchanges and are used by investors to hedge against market fluctuations. For example, a farmer may use a futures contract to sell their crop at a specific price in the future, locking in a profit and protecting against price fluctuations.
2. Options Contracts: Options contracts give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price before a specified expiration date. There are two types of options contracts: call options and put options. A call option gives the holder the right to buy an underlying asset at a specific price, while a put option gives the holder the right to sell an underlying asset at a specific price. For example, an investor may buy a call option on a stock they believe will increase in value, giving them the right to buy the stock at a specific price before the option expires.
3. Swaps: Swaps are agreements between two parties to exchange one stream of cash flows for another. Swaps can be used to hedge against interest rate or currency fluctuations or to speculate on market movements. For example, a company may enter into a currency swap to hedge against fluctuations in exchange rates when doing business in a foreign country.
4. Forward Contracts: Forward contracts are similar to futures contracts, but they are not traded on exchanges. Instead, they are privately negotiated between two parties. The buyer and seller have the option to alter the terms, size, and settlement procedure when creating a forward contract. Forward contracts have higher counterparty risk for both parties because they are OTC items. Forward contracts can be customized to meet the specific needs of the parties involved, but they carry more counterparty risk than exchange-traded futures contracts. For example, a company may enter into a forward contract to buy a commodity at a specific price in the future to ensure a stable supply of raw materials.