Derivative instrument is a contract between two parties that
emphasizes conditions ( including dates that result in values of the underlying
variables and notional amounts) under which payments can be made between both
the parties.
Derivatives are used by investors for the following reasons:
1)
It provides leverage with a small movement in the underlying value that causes
a large difference in the value of the derivative.
2)
One can often speculate and make a profit, if the value of the underlying asset
goes in the way they expect.
3)
It mitigates the risk in the underlying, by making an entry in the derivative contract
whose value moves in the opposite direction, stays in or out of a specific
range and may reach a certain level.
4)
It can obtain exposure to the underlying where it may not be possible to trade
in the underlying derivatives.
5)
It has the ability to create options, where the value of the derivative is
linked to a specific condition or event.
When Derivatives allow risk related to the prices of the
underlying asset to be transferred from one party to another, it is known as
Hedging. Both the parties have a reduction in a future risk, however there is
still a risk of the non-availability of the resource that may back-track
because of the events unspecified by the contract such as natural damage, may
cause problems on the contract.
Although a third party, which is also known as a clearing
house, it insures a futures contract, not all derivatives can or will be
insured against a counter-party risk.
Derivatives are also used to acquire risk, rather than
hedging the risk. Thus, some investors or institutions can enter in a
derivative contract to speculate on the value of the underlying asset.
These speculations look to purchase an asset in the future
at a really low price which according to the derivative contract maybe a high
price to sell the asset in the future when the market price is low.
An OTC or over-the-counter derivative is a contract that is
privately traded and negotiated between two parties without going through an
exchange.
Exchange-traded derivative contracts are those derivatives that
can be traded via specialized derivative exchange or other exchanges. There is
a market where derivatives exchange acts as an intermediary to all transactions
and takes an initial margin from both the sides of the trade to act as a
guarantee.
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