What is a derivative?

3 months ago
29 in financial

If you follow financial news or watch videos on Youtube about finance you might heard the term derivative dozens if not hundred of times. Many people refer to them as a gamble or as an insurance policy. But really, what is a derivative?
Well, for starters, a derivative is a financial instrument which means that it is a financial contract that can be bought or sold. This financial contract derives its value from an underlying asset which can be a share, a commodity, a bond or even a notional asset that does not even need to exist.
There are basically three types of derivatives: futures, options and swaps.
Future contracts originated in Chicago back in the 19th century when individuals trading pigs wanted to lock in prices in advance. So, for instance, if you wanted to buy a pig three months down the line but you thought that pig prices would go up you could buy a futures pig contract a buy a pig in three months' time at a price agreed today. If, for example, the price of a single pig was, say $5 and in three months the price went up to $7, you could buy the pig for $5, sell it for 7$ and make a profit of 2$ in the process. The person agreeing to sell you the pig is what we would call the counterparty. If you are a counterparty to a derivatives contract and you do not hold the asset that you are agreeing to sell in the future that is called a naked future.
So, to summarize, if you thought that pig prices were going to go up, you would buy a pig future in order to buy the pig at a cheaper price than the price at that point in the future and resell it afterwards. If on the other hand you thought that pig prices would go down, you could sell a pig future in order to sell a pig at a higher price than the spot price at that point in the future. Notice that if the counterparty buying only wishes to make a profit and is not interested in getting the underlying asset you can simply gamble on the pig prices without having to exchange any pig when settling the contract.
We can extend this idea of buying and selling pigs to any commodity or even to shares in companies. When you buy a futures contract it is said that you are going long and when you are selling a futures contract it is said that you are going short, or simply that you are shorting X underlying asset. Hence traders short gold, oil, etc or can, on the other hand, go long gold, oil, etc.
Back in the 70s, a new type of future was created which allowed to trade financial instruments like shares or bonds.
Once you understand what a future is, it is easy to understand what an option is. An option is similar to a future contract in that you are arranging to buy or sell and underlying asset at some point in the future but here you have the option to carry on with the contract, hence the name "option". The person selling the option is called the writer and they receive a premium from the person buying the option. The person buying the option pays the premium and if by the time the contract has to be settled it is not in the interest of the buyer to settle the contract then the writer keeps the premium and the person who bought the option loses the premium. If for instance you thought that shares in say, Boeing are going to go up in three months down the line, you could buy "call" options on Boeing (where the term "call" means that you are willing to buy). If three months pass and Boeing's share price has gone up, you could demand the shares from the writer of the "call" option. If, on the other hand, Boeing's share price has gone down, then if you decide to exert you right to buy the share you would be making a loss that is why you would not exert the contract and just let the writer keep the premium.
The other type of option is the "put" option. You would buy a put option if you are willing to have the right to sell and underlying asset at some point in the future. If for instance, you thought that Boeing's share price is going to fall in the future, then you would buy put options on Boeing which would force the writer to buy Boeing shares in the future at a higher prices than the spot prices at that point in the future.
Finally, swap contracts are financial instruments that allow individuals or institutions to exchange cashflows. Two companies can make payments for each other if that is in the interest of both companies. There are basically two types of swaps: interest rates swaps and currency swaps.
Well, if you did not what a derivative was, I hope you find this article helpful. Thanks for reading.

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