A derivative is a financial instrument Alternatively, financial instruments can be categorized by "asset class" depending on whether they are equity based or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorised into short term (less than one year) or long term that is derived from some other asset In business and accounting, assets are economic resources owned by business or company. Anything tangible or intangible that one possesses, usually considered as applicable to the payment of one's debts is considered an asset. Simplistically stated, assets are things of value that can be readily converted into cash . The balance sheet of a firm, index In economics and finance, an index is a single number calculated from a set of prices or of quantities[citation needed]. Examples include the price index, quantity indexes , market performance indexes (such as a labour market index / job Index and stock market indexes). Values of the index in successive periods (days, years, etc.) summarize level, event, value or condition (known as the underlying In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying. There must be an independent way to observe this value to avoid conflicts of interest asset). Rather than trade or exchange the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. A simple example is a futures contract A futures contract is a standardized contract to buy or sell a specified commodity of standardized quality at a certain date in the future and at a market-determined price . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still securities,: an agreement to exchange the underlying asset at a future date.
Derivatives are often highly leveraged In finance, leverage or leveraging refers to the use of debt to supplement investment. Companies usually leverage to increase returns to stock, as this practice can maximize gains . The easy but high-risk increases in stock prices due to leveraging at US banks has been blamed for the unusually high rate of pay for top executives during the recent, such that a small movement in the underlying value can cause a large difference in the value of the derivative.
Derivatives can be used by investors to speculate and to make a profit if the value of the underlying moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). Alternatively, traders can use derivatives to hedge In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out.
Derivatives are usually broadly categorised by:
- The relationship between the underlying and the derivative (e.g. forward A forward contract or simply a forward is an agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in, option In finance, an option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset on or before the option's expiration time, at an agreed price, the strike price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option, swap In finance, a swap is a derivative in which two counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. Specifically, the two counterparties agree to exchange one stream of cash flows against)
- The type of underlying (e.g. Freight derivatives based on Baltic Exchange The Baltic Exchange is the world's only independent source of maritime market information for the trading and settlement of physical and derivative contracts. Its international community of over 550 members encompasses the majority of world shipping interests and commits to a code of business conduct overseen by the Baltic shipping indices), equity derivatives In finance, an equity derivative is a class of financial instruments whose value is at least partly derived from one or more underlying equity securities. Market participants trade equity derivatives in order to transfer or transform certain risks associated with the underlying security. Options are by far the most common equity derivative,, foreign exchange derivatives and credit derivatives In finance, a credit derivative is a derivative whose value is derived from the credit risk on an underlying bond, loan or other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of)
- The market in which they trade (e.g., exchange traded or over-the-counter Over-the-counter trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges)
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