Issue #5: Derivative
The first known use of the term derivative in the English language was in the 15th Century. The word derivative as used in the English language has its origins from the French word derivatif which itself is derived directly from modern Latin derivativus which is also from an older Latin past-participle variant derivare which means “to lead or draw off”, “taken to have proceeded from another or others”, “secondary.”
In finance, derivative is a financial security with a value that is reliant upon or derived from an underlying asset or group of assets. It is a financial contract having a value deriving from an underlying variable asset. The derivative itself is a contract between two or more parties and the derivative derives its price from fluctuations in the underlying asset. This underlying asset is referred to as a benchmark.
The underlying asset includes bonds, stocks, commodities, currencies, interest rates, common indexes, weather events etc. All these are traded in the derivatives market through different types of derivative.
They are basically used to hedge against risk. These derivatives have no direct value in and of themselves, their value is based on the expected price movement of the underlying asset.
Types of Derivatives
The types of derivatives include:
Futures contracts: This is a standardised derivative contract used to buy a particular commodity or asset at a preset price and at a preset time or date in the future. The underlying asset here are usually commodities e.g. crude oil, cocoa, coffee beans, maize etc.
Options: This is a derivative contract between two parties to facilitate a particular transaction on the underlying security or asset at a preset price, referred to as strike price, prior to the expiration date. The underlying asset here are usually securities e.g. stocks. There are two types of options contract which are call options and put options.
Forwards: This is a customised derivative contract between two parties to buy or sell an asset at a specified on a future date. Though similar, a standout difference between futures and forwards is that while futures contracts are standardised and traded on an exchange, forward contracts are customised and are traded over-the-counter (OTC). There are other differences that will be discussing when in subsequent issues.
Swaps: This is a type of derivative contract through which parties exchange cash flows or liabilities from two different financial instruments. An example is the interest-rate swap through which parties hedge against interest rate risks.
I will be discussing these types of derivatives individually in subsequent issues of Finance “Yoga”.
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Features of Derivatives
- They are financial contracts between two or more people.
- They are secondary securities whose value is solely based on the value of the primary security they are linked to ergo underlying asset.
- Ownership of a derivative does not necessarily mean ownership of the asset.
- They are used to mitigate future risks. This is referred to as hedging.
- They are also used to assume risk with the possibility of future reward. This is referred to as speculation.
Usage in a Sentence
So now we can say;
“I want to invest in the derivatives market.”
” Emmanuel said that the utilisation of blockchain technology in the securities market will take away the role of middlemen while trading in derivatives.”
“The future of investing in derivatives are in commodities.”
I hope you have learnt something today. If you have any question, observation or remark please put them in the comments section.
Remember, finance is not that hard!
See you next week!
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