Derivatives are securities with prices that are dependent on, or derived from, one or more separate underlying assets. The derivative itself is a contract between two or more participants founded on these underlying assets.
Their value is determined by the fluctuation in the price of the underlying assets. The most common types of underlying asset are stocks, commodities, bonds, currencies, market indexes and interest rates.
How Derivatives Work
A derivative contract is either traded on an exchange or over-the-counter (OTC). OTC contracts make up a larger proportion of the contracts that exist and are not regulated, while a derivative that is traded on an exchange will be standardized. An OTC derivative will generally have more risk for the counter party to the contract than a standardized derivative will.
Derivatives were originally used for ensuring a balanced exchange rate for goods that were traded internationally. With different values among different national currencies, traders required a system for accounting for these differences.
Since they are a category of security and not a specified kind, numerous different sorts exist. Therefore, they have a broad range of purposes, functions and applications that are founded on the derivative’s particular type.
Derivatives for Hedging
Certain types will be used for hedging, which insures against an asset’s risk. They will also be used to speculate in bets on the future prices of assets or for circumventing issues associated with exchange rates.
As an example, European investors who purchase the shares of a company in America from an exchange in America, and use U.S. dollars for doing so, will be exposed to risk from the exchange rate while they hold that stock.
To hedge against this currency risk, the investor will purchase a currency futures contract to lock in a specific exchange rate for the future sale of that stock and the subsequent currency conversion of the return back into Euros.