What are Derivatives?
A stock derivative is a financial instrument that contains a value based on the expected future movement and prices of the asset to which it represents or is linked to. The assets in a stock derivative are stocks; however, a derivative in general can take the form of any financial instrument included currencies, commodities, and bonds.
Derivatives, because of their complexity and uniqueness, are referred to as “alternative investments.”
A derivative, on its own, possesses no value; however, the more basic types of derivatives are traded on markets before their expiration date as if they were generic assets.
Relationships and Characteristics of a Derivative
Derivatives are categorized by the following relationships and characteristics:
1. The relationship between the underlying equity or asset and the derivative itself, meaning the nature of the contract i.e. swaps options or forwards.
2. The type of underlying asset that is being exchanged (i.e. foreign exchange derivatives, interest rate derivatives, commodities, credit derivatives, or equity derivatives.
3. The market in which the derivative is exchanged and transacted (i.e., over-the-counter derivatives or exchange-traded derivatives.
4. The pay-off profile attached to the derivative.
5. The characteristics attached to the derivative, meaning is the derivatives vanilla or exotic in nature?
Why are Derivatives used?
Derivatives may be used for a variety of reasons; however, investors will commonly take part in these forms of transactions for the following reasons:
1. Derivatives provide leverage so that a small movement in the underlying value of the asset can create a large difference in the value of the derivative contract.
2. Derivatives enable investors to speculate and generate a profit from the transaction if the value of the underlying financial instrument moves the way that they expect. For example, investors commonly purchase or take part in a derivative agreement based on a notion that a stock moves or stays in or out of a specific price range.
3. Derivatives are commonly used to mitigate or hedge risks of an underlying asset. By purchasing or entertaining a derivative contract an individual can obtain both side of a value move, meaning they can play the opposite direction to their previously position to cancel some or all of their exposure to a given financial investment.
4. A derivative will also help obtain exposure to the underlying financial asset where it is not possible, in normal circumstances to obtain such a right. For example, investors can partake in weather derivatives.
5. A derivative contract also offers the ability for the investor, where the value of the derivative contract is linked to a specific condition or event.