What is a Derivative?
A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a stock or bond), index, or security. Common underlying instruments include stocks, bonds, commodities, currencies, interest rates, and market indexes. Derivatives are often used for hedging risk or for speculation.
Key Types of Derivatives
- Futures Contracts: An agreement to buy or sell an asset at a predetermined price at a specified time in the future. Futures are traded on organized exchanges.
- Options Contracts: Gives the buyer the right, but not the obligation, to buy (a "call" option) or sell (a "put" option) an underlying asset at a specific price on or before a certain date.
- Swaps: A contract through which two parties exchange the cash flows or liabilities from two different financial instruments. An interest rate swap is a common example.
The Purpose of Derivatives
Derivatives can be powerful tools for managing risk. For example, a farmer can use a futures contract to lock in a price for their crop, protecting them from falling prices. However, they are also used for speculation, which involves betting on the future price movements of an asset. Due to their complexity and the leverage involved, derivatives can be extremely risky and are generally recommended only for sophisticated investors.
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