What are derivatives?

     WHAT ARE DERIVATIVES?

     Today we often hear that derivatives are one of the fastest growing segments in the financial market. But what are derivatives? Many beginning investors do not really understand what derivatives are but as soon as you'll understand it you will be on your way to getting a good return on your investment.

     First of all everyone who wants to achieve success in this business and make money owing to derivatives have to know that, unlike financial instruments such as stocks and bonds, derivatives are usually contracts rather than assets. Derivative is a financial security the value of which is derived in part from the value and characteristics of another security or commodity, so called underlying asset. In fact they are binding contracts for a person to buy or sell an asset at some point in the future, but the person is paying for it in the present. You can buy/sell a foreign currency or a stock of a company, oats or oil, or if we take an extreme case, it can be an agreement with your neighbour for 3 bags of salt next week.

     ESSENCE OF DERIVATIVES

     Derivatives are important in the world of finance because they allow for hedging and managing risk. However, since derivatives have no value themselves and are dependent on the value of another asset, there is a greater risk associated with them. While they can lead to quick profits, derivatives are best taken up by those who can understand the relationships between product volume, price trends and consumer interest.

     One example of how a derivative works: a contract between the Japanese rice farmers and the rice warehouse merchants. A rice farmer signs a contract with a merchant in April that would allow the merchant to pay the farmer a set amount of cash. In exchange for the immediate cash, the rice farmer would deliver a certain amount of rice after the harvest, in autumn. The rice farmer has lowered the business risk (he has received a certain price for the rice), while the merchant has locked in the price for a certain amount. However, the wisdom in the exchange will be decided in autumn, especially if there is a shortage or overabundance of rice.

     TYPES OF DERIVATIVES

     Types of derivatives include: futures, options, swaps, forward contracts and so on.

     An options contract is an agreement giving the right, but not the obligation, to buy or sell a security or commodity at a particular price at a particular future time, or in a period of future time. There are two types of options contracts: a call or buyer's option and a put or seller's option. A call option gives the right to buy securities (or a currency, or a commodity) at a certain price during a certain period of time; whereas a put option gives the right to sell an asset at a certain price during a certain period of time.

     A futures contract is an agreement giving an obligation to sell a fixed amount of an asset at a particular price on a particular future date. These are standardized deals for fixed quantities that are carried out with the help of brokers between investors who don't know each other. Whereas individual, non-standard, "over-the-counter" deals between two parties are called forward contracts.

     A swap is a derivative in which two counterparties agree to exchange one stream of asset against another stream. At present many companies arrange currency swaps and interest rate swaps with other companies or financial institutions. For example, a French company that can borrow francs at a preferential rate, but which also needs yen, can arrange a swap with a Japanese company in the opposite situation. Such currency swaps are designed to achieve interest rate savings, but they are also open to risk, because whether a company saves or loses money will depend on the movement of interest.