Common types of derivatives include futures contracts, forwards, options, and swaps. Derivatives can be a convenient way to achieve financial goals but can also include counterparty risk, inherent risks of leverage, and systemic risks.
What Is a Derivative?
Derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. Two or more parties can trade on an exchange or over the counter. Prices for derivatives are driven by the fluctuations in the underlying asset. Derivatives are usually leveraged, which can increase the potential risks and rewards.
Derivatives are a form of advanced investing. Most common underlying assets are stocks, bonds, commodities, currencies, interest rates, and market indexes. Derivatives were originally used to ensure balanced exchange rates for internationally traded goods.
Types of Derivatives
There are two classes derivative products: “lock” and “option”. Futures, forwards, and swaps are some types of “lock” derivative products. These lock products bind the respective parties from the outset to the agreed upon terms over the life of the contract. Options, however, offer the holder the right, but not an obligation, to buy or sell the underlying asset or security at a given price on or before the option’s expiration date.
A futures contract, simply known as futures, is the agreement between two parties for the purchase and delivery of an asset at an agreed upon price at a future date. Futures are contracts that trade on an exchange.
A forward contract is like futures but is not traded on an exchange and is only over the counter. When a forward contract is created, the buyer and seller may customize the terms, size, and settlement process. An options contract is also like a futures contract in which two parties agree to buy or sell an asset at a predetermined future date for a specific price. The major difference between futures and options is that with an option, the buyer is not obligated to exercise their agreement to buy or sell. Options are only an opportunity, whereas futures are an obligation.
Swaps are used to exchange one kind of cash flow for another. For example, a trader might use an interest rate swap to switch from a fixed interest rate loan to a variable interest rate loan.
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This overview is for informational purposes only and is not a recommendation. It should not be the sole deciding factor in making an investment. Investing is a risk and, as with all risks, a positive return is not guaranteed. Past performance does not indicate future results.