A derivative is a financial contract whose value is derived from the performance of an underlying asset. It does not have independent value but is linked to the price movements of assets like stocks, indices, commodities, or currencies. Derivatives are used for hedging risks, speculating on market movements, or arbitraging price differences.
Derivatives in Financial Markets
In financial markets, derivatives act as tools for managing risk or gaining exposure without directly owning the asset. They are traded either on exchanges (standardized contracts) or over-the-counter (customized contracts).
Key Points:
- Derived Value: Derivatives get their value from underlying assets.
- Not an Asset: They are contracts, not physical or real financial assets.
- Purpose: Used for hedging, speculation, and arbitrage.
- Popular Markets: Traded on both exchanges (regulated) and OTC (over-the-counter).
- Risk Transfer: Help manage price, interest rate, or currency fluctuation risks.
Types of Derivatives: Forwards, Futures, Options, Swaps
Each type of derivative contract serves different needs and carries different risks and structures.
Why Use Derivatives?
Derivatives are powerful financial instruments used by a wide range of market participants. The primary reasons for using derivatives include hedging against risk, speculating on price movements, and profiting from price inefficiencies through arbitrage. Each of these functions plays a distinct role in financial markets.