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What Is A Derivative?

A derivative is a contract between two or more parties in which the value of the contract is determined by an agreed-upon underlying financial asset (such as security) or collection of purchases (like an index).

Deeper Definition

Derivatives are secondary securities whose value is exclusively derived from the importance of the original security to which they are linked. Derivatives are often considered a sophisticated investment.

Derivative goods are divided into two categories: “lock” and “option”. Lock products (such as swaps, futures, or forwards) commit the parties to the agreed-upon conditions from the start and the contract’s duration. On the other hand, options products (such as stock options) provide the holder the right but not the duty to purchase or sell the underlying asset or security at a predetermined price on or before the option’s expiration date. While the value of a derivative is predicated on an asset, owning a derivative does not imply owning the asset. Derivatives such as futures contracts, forward contracts, options, swaps, and warrants are extensively employed.

Derivative Example

1. Futures Contracts

Because the underlying asset’s performance influences the value of a futures contract, it is a derivative. A futures contract is an agreement to purchase or sell a commodity or investment at a defined price and on a future date.

2. Equity Options

Because its value is “derived” from the underlying stock, an equity or stock option is derivative. Calls and puts are two types of options. A call option offers the holder the right to purchase the underlying stock. This is at a defined price (known as the strike price) and by a specific date specified in the contract (called the expiration date).

3. Derivative Swap

Interest-rate products can also benefit from derivatives. The most common application of interest rate derivatives is to protect against interest rate risk. Interest rate risk occurs when the price of the underlying asset changes due to a change in interest rates.

Loans, for example, can be offered as fixed-rate loans (with the same interest rate throughout the loan’s life) or variable-rate loans (with the rate fluctuating dependent on market interest rates). Some businesses may choose to convert their variable-rate loans to fixed-rate loans.

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