Derivatives are financial contracts between two parties doing business whose values are derived from the values of previously agreed upon assets. A derivative can be defined as financial security whose value depends on (or derives from) the values of other, more basic underlying variables or assets.
These act as secondary security in financial dealings between two parties. Very often the variables regarding the underlying derivatives are the prices of traded assets such as - bonds, stocks, commodities, interest rates, market indexes etc.
A stock option, for example, is a derivative whose value is dependent on the prices of a stock. However, derivatives can depend on almost any variable, from price cows to the amount of snow falling at a certain ski resort. They are widely used to speculate on future expectations or to reduce a security portfolio risk.
Types of Derivatives
There are two broad type derivatives in the market depending on how they are dealt with and they are -
- Over the counter
- Exchange-traded
The four listed below are some of the common types of derivatives -
- Future
- Swap
- Forward
- Options
All these four kinds can be used in an over-the-counter and exchange-traded manner.
Use of the Term in Sentences
- The estimated exchange rates are the major variable in terms of derivatives.
- Future contracts, forward contracts, and warrants are three of the most common derivatives used in the market.