What is Derivatives- Definition, Benefits and its Types

One of the most meaningful tools in the contemporary financial markets is derivatives. Understanding derivatives may lead to chances for portfolio diversification, speculative gains, and threat hedging, despite their seemingly complicated nature. The description, operation, kinds, benefits, and downsides of derivations will all be covered in this article, along with examples and often-asked questions.

What are Derivatives?

Like stocks, commodities, currencies, interest rates, or market indices, derivatives are financial agreements whose worth is established on a fundamental asset.  Derivatives allow dealers and investors to assume price differences or defend themselves from implied losses rather than holding onto the asset.  These agreements are frequently used to avoid crises, improve power, or capitalize on transformations in the market. For example, a dealer can use a gold futures contract to lock in the current price and destroy the possibility of future price changes. In conclusion, derivatives are practical tools for financial market readiness, safety, and profit.

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Types of Derivatives

There are four primary types of derivative contracts in financial markets:

1. Futures Contracts

Standardized agreements to buy or sell an item at a destined price at a later time are known as futures contracts. Because these arrangements are changed on regulated exchanges like the NSE or BSE, the counterparty threat is dropped and clarity is assured. Trading goods, indices, stocks, and currencies is a standard operation for futures. They're fairly binding, which means that both parties have to abide by the conditions of the contract when they expire. Every day, futures are pronounced- to market, and both buyers and merchandisers must deposit margin. Futures are used by dealers for both threat hedging and price movement speculation. In futures trading, leverage may increase earnings as well as losses.

2. Options Contracts

The buyer has the choice, but not the responsibility, to buy or sell an asset at a predetermined price before or on a given date.  Call options (right to purchase) and put options (right to sell) are the two types. The vendor (writer) receives compensation from the buyer for this ownership. Options are widely used in stock markets for hedging and speculative strategies. They offer flexibility with limited downside risk for the buyer, while the seller may face higher risk. Options can be combined in strategies like straddles and spreads for more advanced trading. Like futures, they are traded on regulated exchanges.

3. Forward Contracts

Private contracts between two parties to purchase or sell a good at a certain price on a predetermined future date are known as forwards.  It can be adjusted and is bartered over-the-counter (OTC) as opposed to futures, which are proposed on exchanges. They are frequently used by corporations to protect themselves against contrasts in commodity or exchange rates. Because there's no exchange securing the deal, forward contracts include counterparty threats. These contracts are settled at the end of the agreement, with no daily mark-to-market. Forwards are less liquid and transparent compared to exchange-traded derivatives. They suit institutional users needing tailored hedging solutions.

4. Swaps

Tailored agreements known as swaps happen when two parties trade financial liabilities, generally cash overflows or interest payments. The most popular is an interest rate swap, which involves swapping fixed and variable interest payments. Commodity and currency swaps are two other kinds that businesses use to reduce threats. Because they're traded over-the-counter( OTC) rather than on sanctioned exchanges, swaps are flexible but subject to counterparty threat. Large associations, banks, and companies employ them more frequently than individual investors. Swaps enhance debt arrangements and reduce financial perils. Their intricacy necessitates professional expertise and supervision.

How to Trade Derivatives?

Trading derivatives can be done through exchanges (like NSE or BSE in India) or over-the-counter (OTC). Here's a step-by-step process:

1. Open a Trading Account with a broker authorized to deal in derivatives.
2. Choose the Derivative Instrument – futures, options, etc.
3. Select the Underlying Asset – stocks, indices, commodities, currencies.
4. Determine the Lot Size and Expiration Date.
5. Place the Order – either for hedging or speculative purposes.
6. Monitor the Position until expiry or exit before expiry.

Note: Derivatives trading involves margin requirements and potential leverage.

Advantages & Disadvantages of Derivatives

Advantage

Disadvantages

Hedging against price volatility

High risk due to leverage

Portfolio diversification

Complex to understand and manage

Cost-effective compared to the underlying asset

May incur large losses if misused

Potential for high returns

Requires continuous monitoring

Liquidity in standardized contracts

OTC contracts have counterparty risk

How Do Derivatives Work?

Let’s say an investor wants to protect themselves against a fall in the price of a stock they own. They can buy a put option as insurance. If the stock price falls, the option’s value increases, offsetting the loss on the stock. Conversely, if the stock rises, the investor only loses the small premium paid for the option.

Derivatives work on the principle of contractual obligation or rights, where two parties agree on a price or value for a future date. The market price of the derivative changes based on the changes in the value of the underlying asset.

Example of a Derivative

Scenario: Hedging with a Futures Contract

Imagine you’re a wheat farmer expecting to harvest 100 tons in 3 months. You fear the price might drop by then. To hedge this risk, you enter into a futures contract to sell wheat at ₹25,000 per ton in 3 months.

• If the price drops to ₹20,000, you are protected and still get ₹25,000.
• If it rises to ₹30,000, you still sell at ₹25,000 — losing the opportunity to gain.

This is a classic use of derivatives for risk management.

Why Do Investors Enter Derivative Finance?

Purpose

Explanation

Hedging

To reduce or manage risk due to price fluctuations

Speculation

To profit from price movements of underlying assets

Arbitrage

To take advantage of price differences in different markets

Portfolio Diversification

To gain exposure to different asset classes with limited capital

Leverage

To control a large position with a relatively small amount of money

Income Generation

Through strategies like covered calls using options