Economy / Stock Market / Derivatives and Futures
Derivatives and Futures
A derivative is a financial instrument whose value is derived from the value of an underlying asset, index, rate, or other reference. Derivatives can be used for various purposes, including hedging against risk, speculating on future price movements, and achieving portfolio diversification. The two main classes of derivatives are futures and options.
- Futures:
- Definition: Futures are financial contracts that obligate the buyer to purchase, or the seller to sell, an asset at a predetermined future date and price.
- Underlying Assets: Futures contracts can be based on various underlying assets, including commodities (e.g., agricultural products, metals), financial instruments (e.g., stocks, bonds), or market indices.
- Trading on Exchanges: Unlike forward contracts, futures contracts are traded on organized exchanges. The exchange acts as an intermediary, ensuring the fulfillment of contract obligations.
- Payment and Margin: A small upfront payment, known as margin, is made when entering into a futures contract. The buyer and seller are required to settle the contract by paying or delivering the agreed-upon amount at the contract's expiration.
- Options:
- Definition: Options are financial contracts that provide the holder with the right (but not the obligation) to buy or sell an underlying asset at a predetermined price (strike price) before or at the option's expiration date.
- Call Options: A call option gives the holder the right to buy the underlying asset.
- Put Options: A put option gives the holder the right to sell the underlying asset.
- Flexibility: Options provide flexibility to the buyer, who can choose whether to exercise the option based on market conditions.
- Premium Payment: The buyer of an option pays a premium to the seller for the right conveyed by the option. The seller, in turn, receives the premium but has an obligation to fulfill the contract if the buyer decides to exercise the option.
Derivatives play a crucial role in risk management, price discovery, and providing market participants with various trading and investment strategies. However, they also involve complexities and risks, requiring careful consideration and understanding by market participants. The regulatory framework for derivatives is designed to ensure market integrity and investor protection.
