What are Derivatives?

What are Derivatives?

• The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. These contracts can be used to trade any number of assets and carry their own risks.
• Common derivatives include futures contracts, forwards, options, and swaps. Prices for derivatives derive from fluctuations in the underlying asset. 
• The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates and market indexes.
  • They are used for various purposes, including speculation, hedging and getting access to additional assets or markets.
• The basic principle behind entering into derivative contracts is to earn profits by speculating on the value of the underlying asset in the future.
• There are mainly two types of derivatives: one that is subject to standardized terms and conditions, and thus being traded on stock exchanges, and the other being traded between private counter-parties in the absence of a formal intermediary.
  • While the first type is known as exchange-traded derivatives, the other is over-the-counter derivatives.
• What are Exchange Traded Currency Derivatives (ETCDs)?
  • They are financial contracts that allow traders and investors to speculate on the future price movements of various currency pairs.
  • These derivatives are traded on exchanges, and their value is based on the underlying currency exchange rate.
• Common Derivatives:
  • Futures Contracts: It is an agreement between two parties to buy or sell an asset at a predetermined price on a specific future date. The underlying asset can be commodities, financial instruments, or indices.
  • Options Contracts: It gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (strike price) on or before a predetermined expiration date.
  • Swaps: They are agreements between two parties to exchange cash flows based on specific financial variables. Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. Swaps are often used to manage interest rate risks, currency risks, or to change the nature of a debt obligation.
  • Forwards: They are similar to futures contracts but are not standardized or traded on exchanges. They are customized agreements between two parties to buy or sell an asset at a specified price on a future date.

Q1: What are bonds?

A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental) for a set period of time in return for regular interest payments. The time from when the bond is issued to when the borrower has agreed to pay the loan back is called its ‘term to maturity’. The bond issuer uses the money raised from bonds to undertake various activities, such as funding expansion projects, refinancing existing debt, undertaking welfare activities, etc.

Source : RBI defers exchange-traded currency derivatives rules