Essay on Derivative

1914 Words Aug 26th, 2010 8 Pages
A derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is nearly endless. Thus, the real definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying.
Some of the widely known underlying assets
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Futures-When two entities decide to purchase or sell an asset at a given time in the future at a given price, it is called futures contract. Futures contracts can be said to be a special kind of forward contracts, as they are customized exchange-traded agreements.

Options-It is of two different kinds such as calls and puts. Those who take calls option, they are not obligated to purchase given quantity of the underlying variable, at a mentioned price on or prior to a scheduled future date. On the other hand, buyers in case of puts option may not necessarily sell a mentioned quantity of the underlying variable at a mentioned price on or prior to a given date.

Swaps-These are private contracts between two entities to deal in cash flows in the future following a pre-decided formula. They are somewhat like forward contracts' portfolios. Swaps are also of two types such as interest rate swaps and currency swaps.

Interest rate swaps-in this case, only interest related cash flows can be exchanged between the entities in one currency.

Currency swaps-in this case of swapping, principal and interest can be exchanged in one currency for the same in other form of currency.
Importance of Derivatives
Financial transactions are fraught with several risk factors. Derivatives are instrumental in alienating those risk factors from traditional

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