Derivatives

A derivative is a financial instrument whose value is derived from another entity which is also known as the underlier. The underlier (or underlying) can range from assets such as commodities, stocks, real estate, and financial indicators such as stock market indices, interest rates, consumer price index.

Other more exotic derivatives have also been launched in recent years. They include derivatives on weather conditions and carbon emissions. The underlier can also be another derivative. Such a derivative of a derivative would be known as a second generation derivative.

Uses of Derivatives

Derivatives can be used by investors to remove (or mitigate) the risk of losses to their holdings that are caused by fluctuations in the value of the underlying. This activity is known as hedging. Owing to the high leverage they provide, derivatives can be also used by traders to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Types of Derivatives

The most common types of derivatives being traded today are options, futures, forward contracts, and contracts for difference (CFD).

By combining the basic derivatives, more complex derivatives can be created. Examples of such hybrids include swaptions and options on futures.

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