What is a derivative?

Competent use of derivatives allows to reduce risks and increase profitability of operations in the markets.

Derivative (“derivative” from persistent.”derivative”) – is a derivative financial instrument from the underlying asset (the main product). Any product or service can act as the underlying asset.

In other words, a derivative is a financial contract between the parties that is based on the future value of the underlying asset. On the market they exist since ancient times, consisted of derivatives on tulips, rice, etc.

It turns out that the owner of the derivatives enters into a contract for the acquisition of the main product in the future, it does not need to think about warehousing and delivery. But this contract is already possible to speculate.

The purpose of the contract is to make a profit by changing the price of the asset. The number of derivatives may exceed the number of assets.

Derivatives are used for:
Hedge (reduce the risk);
Speculations’.
Well-known financier Warren Buffett in 2002 called derivatives “financial weapons of mass destruction.” Financial analysts directly link the latest global financial crisis with market speculation. The value of derivatives significantly exceeded the value of underlying assets.

The most common derivatives:
Future;
Forward;
Option.
Futures contracts (“future” from English.”future”) are agreements for the purchase/sale of the underlying asset at the price agreed at the time the contract is entered into. Itself buying / selling is happening in a certain moment in the future. Futures work only on the stock exchanges, is a standard contract.

Forward (“forward” from persistent.”forward”) is the OTC equivalent of the futures, which is a non-standard contract. Terms of purchase / sale are determined only between buyer and seller.

Option (“choice” from persistent.”option”) gives the right to the buyer to carry out the transaction of purchase/sale subject to payment of the option to the seller of remuneration. Under the option contract, the buyer has the right to fulfill its obligations. The seller is obliged to execute the transaction according to the agreed terms.

All contracts involve delivery of the underlying asset in the future on the terms agreed in the contract.

To understand what derivatives are, you can use the example of buying a car:

In salon of the dealer the brand of the car is chosen. Then the color of the car, engine power, additional equipment is determined and the purchase price is fixed. A Deposit is made and a forward contract is concluded for the purchase of the machine in 3 months. Regardless of price fluctuations in the market, you have acquired the right and obligation to buy a car at a previously negotiated price.
You liked the specific machine, but you can buy it only in a week. You can enter into an optional contract with the supplier: pay him $ 100 and ask not to sell the car until the end of the week and not to raise the price. You acquire the right, but not the obligation to buy the car at the stated price. You can refuse to buy, if you find in another salon cheaper option.
There are risks and benefits to both options.

Risks:

The dealer will not deliver the car on time or liquidate the business;
The car will fall in price in the foreseeable future.
Benefit:

– The car will rise in price in the foreseeable future.

Competent use of derivatives allows to reduce risks and increase profitability of operations in the markets.