What is a derivative?
A derivative is a contract between two or more parties that derives its value from an underlying asset, be it company shares, a commodity like gold, or cryptocurrencies. These contracts can be traded like company shares on an exchange or directly between investors.
Derivatives are often used by investors to protect investments from market downturns or for speculative investments. When investing in derivative instruments, we’re taking a bet on the price of an asset over a specified period. This allows companies to hedge against risks associated with the price of an asset that could impact a certain area of their business. For example, a shipping company will bet on the price of oil going up at a certain date. That way, if the price of oil does go up and their costs are impacted, they aren’t hit as hard.
There are four main types of derivatives:
- Futures – an agreement between two parties to buy and sell the contract at an agreed upon price on a future date.
- Forwards – the same as a futures contract but a forwards agreement can be customised to the underlying asset.
- Options – where a futures agreement is based on an agreement to buy and sell on a specific date in the future, an options agreement is bought or sold on or before a certain date.
- Swops – an exchange of assets that have the same current value.