What are derivatives?
Derivatives, as the name suggests, are financial contracts that derive their value from an underlying asset, which can be anything from commodities such as oil or gold, stocks, currencies or even other derivatives. Profits and losses are made as the value of the underlying assets fluctuate. There are several varieties:
Futures, which are an agreement for the purchase and delivery of an asset at an agreed price on a future date. They are traded on an exchange, and the contracts are standardised.
Forwards, which are similar to futures, but are not traded on an exchange, and may have their terms customised by the involved parties.
Swaps, most commonly used to exchange cash flow types, such as fixed for variable interest rate loans.
Options, where the buyer has the option not to honour their obligation to buy or sell, but purchases the contract in order to have the opportunity.
Derivatives are commonly used by businesses to mitigate risks and stabilise prices. However, they are difficult to value, and their price is susceptible to market sentiment and risk. It is also worth noting that fraud is common in the derivatives market.
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