A derivative is a contract or a security that is done between a minimum of two parties and is based on a set of financial assets. These include commodities, currencies, stocks, market indexed and interest rates. Derivatives belong to the domain of a technical investing and are used for hedging and speculation. The derivatives can have a positive or negative effect on the economy. Investors can make a profit on the drop or rise in changes in price or when speculating if the risks are not identified, it can result in a daisy-chain effect or a domino effect. All the related institutions and corporation can become bankrupt at the same time due to a badly written derivative.
Common types of Derivatives
Exchange Traded Options: It is also known as the listed options and is the most used form of trade options. Exchange Traded describes the options contracts that are present in the public trading exchange. A broker is used to buy or sell these contracts.
Swaps: Interest rate swaps or currency swaps are a common derivative contract for banks, financial institutions, and other organizations. They can make a debt which is at a fixed-rate to floating or the reverse to reduce risk and also make it harder to repay the debt. These swaps have a major bearing on the balance sheets and it also helps in stabilizing cash flows.
Employee Stock Options: It is given to the employees as a compensation for working in the company. This type of derivative helps the employees to buy the company stocks at a specific price in a given time. The employee buys these stocks with the hope that the price of the stock increases before the expiration date of the derivative. The employee can then sell the stock at a higher price in the market thereby making a profit. Some employees retain the stocks and accumulate it to stake a larger claim in the company.
Futures Contracts: These contracts are mostly used in commodities market though it also exists in stock indices or Dow Jones Average. The way these contract works is: If you have a piece of farm and you grow strawberry in abundance, you can approach the futures market and make a contract to deliver your product on an agreed price at a specific date after you estimate the cost, risk and the profit you can earn. Another party will buy your contract and you deliver the product to them.
There are many financial experts who are not a great fan of derivatives including Warren Buffett. He is of the opinion that these are financial weapons that is hugely destructive and can be latent now but potentially lethal. Many people have gone bankrupt after investing in call options or in financial institutions. Before investing in a firm it is best to understand the derivatives of the business by going through the disclosure documents. If the derivatives of the business are not understood, it is best to avoid it. Ensure that you are your investment adviser, take the risks and your needs into consideration before investing.