Essay on Derivative

1914 Words Aug 26th, 2010 8 Pages
DERIVATIVES
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
…show more content…
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

More about Essay on Derivative