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Derivatives: Definition, Types, Benefits, and Risks

Derivatives are financial instruments whose value is based on the underlying assets. They are a contract between two parties.The most common underlying assets for derivatives are stocks, bonds, currencies, interest rates, commodities, and market indexes. Derivatives can lead to significant profits but remember they are not without risks. You can follow a sebi registered telegram channel to learn the current trends on the use of derivatives.

Hence, it becomes essential to properly understand and manage derivatives to prevent the risks. In this article, we are going to break down what derivatives are, explain their meaning , their advantages, and potential risks.

Definition of Derivatives

A derivative is commonly defined as a financial contract. It is a contract between two parties and its value is determined by the value of an underlying asset or set of assets. The most commonly considered assets are:

• Stocks

• Bonds

• Currencies

• Commodities

• Market indices

In response to the market volatility the value of these underlying assets varies. The whole idea of this contract is based on getting the benefit by betting on the future value of the underlying asset.

If we consider the probability that the prices of the market will increase or decrease. There are also chances that the stock value drops and you may lose money. When you enter a derivative contract, you can generate gains by placing a right bet. On the other hand you might protect yourself from losses in the stock market.

Types of Derivatives

Here are the types of Derivatives:

1) Forwards

It is a customized contract between two parties to buy or sell an asset, a commodity, or a product at a pre-defined cost at a future date. These derivatives are not traded on central exchanges but sold over the counter. They are also not standardized to be controlled. Even if these derivatives don’t promise any profit, they are very effective for preventing or hedging the risks.

Remember the over the counter Forward may lead to counterparty risks. It is a type of credit risk in which the seller or buyer goes bankrupt and is unable to fulfill their duties. In such cases the other party has no remedy to rescue their position.

2) Options

They are also quite similar to Forwards. In these financial contracts the buyer or seller are given the option to sell or buy a security or financial asset but they are not obliged to do so. It is basically a contract between two parties to sell or buy a security at a specific price in the future.

The only difference is that these parties are not under any legal obligation to keep their end of the contract. It means they can simply sell or buy the security at any time. This option is usually provided to decrease the risk if there are market fluctuations in the future.

3) Futures

These financial contracts are also very similar to Forwards. The only difference is that there can be an exchange of features that can result in standardization and regulation. In commodity assumptions, these derivatives are most commonly used.

4) Swaps

As the name implies, these financial contracts are exactly what their name sounds like. These financial derivatives are used to convert a type of cash flow into another. They are private contracts between two parties but they are not traded on the stock exchanges but are exchanged over the counter.

There are two types of swaps that are most popular currently. One is Currency swaps and the other is Interest rate swaps. The Interest rate swaps are used to convert a fixed-interest loan to a variable interest loan and vice versa.

Benefits of Derivatives

Here are some of the advantages of derivatives:

1. Risk management: Derivatives are a very powerful risk management tool. They protect the investors' hedge against any uncertainty and price volatility. For example a farmer can make a stable income by using future contracts. He can then protect himself from the fluctuations in crop prices in future.

2. Leverage: An investor can control a larger position with a very small upfront investment. It will increase his return in future. For example you can use Options contracts to gain significantly by investing a fraction of capital used to buy underlying assets.

3. Price Discovery: While investing in derivatives you can explore new ranges of prices in the market. It will let you know the collective expectations of investors. While making investments in future contracts, they will provide you the real time price of a certain asset. This will also maintain transparency in the market.

4. Diversification: Derivatives make your portfolio diverse in nature. You will be investing in a number of assets. This way your overall risks will be decreased. You can use commodity derivatives for the diversification of your portfolio which is heavily concentrated on equities.

5. Market Efficiency: It ensures liquidity by facilitating flow of capital. This will improve the market efficiency. Liquidity is offered by future and Option derivatives. You can sell or buy commodities seamlessly.

Risks of Derivatives

Here are some of the risks associated with derivatives:

1. Complexities: They can be complex and need a thorough understanding. Any misconception may lead to loss of assets. Before you make any investment, educate yourself.

2. Leverage Risk: Leverage can surely make you gain profit but in volatile market situations, it can lead to significant loss. You need to fix the level of leverage cautiously and stay aware of the associated risks.

3. Counterparty Risk: The derivatives expose you to counterparty risk. You need to be very cautious while engaging in OTC transactions for your financial stability.

4. Market Risk: Derivatives are based on the market movements. Any adverse fluctuation may cause loss. You should regularly evaluate the market volatility to make changes in your derivatives positions.

5. Regulatory Risks: Regulatory changes can impact the derivatives market. First, understand these risks and adapt the trading strategies according to them.

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Conclusion

You can increase your financial gains significantly with the help of derivatives. However, they come with a number of risks. To hedge against these risks and maximize your profits you need to have a thorough understanding of all the complexities that are involved. You can effectively navigate the derivatives market by educating yourself properly about the market dynamics.