Everything You Wanted To Know About Derivatives But Were Afraid To Ask
From call options to put options, forwards to futures, we break derivatives down and answer all the questions you were afraid to ask.
Derivatives: financial securities whose value is based on, or derived from, that of an underlying asset. That asset could be money, bonds or agricultural produce — or anything. Derivatives can be used to “hedge,” or mitigate risk, i.e. you can use them to limit your potential losses. But because the markets for derivatives are much larger than those for the underlying assets (some estimate that the market is more than $250 trillion), as a speculative tool, derivatives can lead to wildly disproportionate gains and losses.
Call options: derivatives that give the buyer the right (but not the obligation) to buy an asset at a certain price on or up to a certain date.
Put options: a derivatives that give the buyer the right (but not the obligation) to sell an asset at a certain price on or up to a certain date.
*Forwards: contracts wherein payment takes place at a predetermined time and price.
*Futures: similar to forwards, but the contract is standardized and traded on an exchange. The Washington Post uses this good example. “A basic agricultural futures contract is a derivative. A farmer today might agree to sell corn to a broker next winter at a certain price. If the price goes up, the farmer misses out on greater profits. But if the price goes down, the farmer is protected from losses.”
*Swaps: exchanges of one security for another, frequently interest rates or securities. The most common kind of swap is an exchange of a fixed rate loan for a floating rate loan, mitigating risk for one party and potentially increasing gains (or losses) for the other.