|Course 408: Derivatives|
The term "derivatives" refers to financial instruments that derive their value from an underlying asset, such as equities, bonds, commodities, or real estate. Some types of derivatives, such as options and futures, might already be familiar to you. These, along with swaps, are among the most commonly used types of derivatives in the financial world. Here are some basic definitions and examples of these three commonly used derivative types.
Futures: Agreement between two parties to buy/sell an asset at some point in the future at a price that is determined today. Although originally developed for use in trading commodities, today commodity futures make up less than one third of futures traded. Other types include equity index (such as the S&P 500) and even interest-rate futures.
Sample uses: A farmer locks in a high price today for crops he will sell at a later date; an airline locks in future jet fuel prices today to guard against potential price increases at a later time.
Options: Gives its owner the right to buy or sell an asset at a given price for a set time period. Because the option represents the right to purchase the asset and not ownership of the asset itself, it typically costs just a fraction of the asset's price. These instruments may be used to gain exposure to equities, ETFs, equity indexes, and commodities. Options come in many varieties and can be used as part of many different trading strategies, such as betting that the price of an asset will go up or that it will go down.
Sample uses: An investor wants to hedge against price swings in a security he or she already owns (covered call); an investor wants to help protect his or her portfolio by buying some downside exposure in case of a market downturn (protective put).
Swaps: Agreement between two parties to trade different payment types over a given time period. These may be used to swap interest-rate or currency exposure, or credit protection (credit default swap).
Sample uses: A bank looking to reduce its exposure to floating interest rates paid on deposit accounts swaps that exposure with another party that can provide exposure to a fixed rate; companies operating in different countries swap currency exposures as a way to reduce currency risk.
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