An Overview of Derivative Contracts |
Posted: October 17, 2018 |
If you have followed any financial markets before, or if you have read financial news daily, you probably have heard something about financial derivatives or derivative contracts. The internet and media is ripe with news articles about such things. And in this article, we aim provide an overview of what derivatives are and its characteristics. Read on Stock Market News! Future DateA derivative instrument is essentially a contract that tells that one commodity may be exchanged at a later date at a fixed price. One must remember that the agreement will basically be worthless if not for the time difference between the setting of the price and the actual execution of the trade. Therefore, the value of the contract is derived from the fluctuation in the price of the underlying asset. Modern day derivatives markets offer a staggering number of options to the buyers and sellers of such contracts. One can actually buy a derivative on almost anything. Obviously, assets like stocks, bonds, and commodities form the basis of the majority of these contracts. Rights and OptionsDerivatives can be characterized by the actual trade taking place at a future date. However, there can be two types of contracts. Some contracts are symmetrical. What this means is that the buyer and the seller are both bound to the agreement. In other words, they have the obligation to push through with the trade. Meanwhile, there are other derivative contracts that are asymmetrical. What this means is that one of the party has the right but not the obligation to push through with the agreement. One must remember that there cannot be a contract wherein both of the parties hold options. The option must be possessed by only one of the party. If both parties hold options, then there isn’t really a contract at all because no decision will be made. High LeverageThere are extremely large leverage ratios. Leverage ratios that are 25 to 1 and 33 to 1 are common while trading derivatives. This is not a defining feature of derivatives, meaning that a contract may not be called derivative contract solely because it uses high leverage. On the other hand, this is the norm with most derivative transaction Trends and Volume Spread Analysis. Time RestrictionSince derivatives are contracts, they have an expiration date. This means that after a specific date they can become completely useless. Thus, they must be used within a given time period or else they don’t hold any value at all. This quite opposed to the general notion of financial assets like stocks and bonds, which usually hold value for a much longer larger period of time. Derivatives, on the other hand, hold value for an extremely short period of time, making this their defining feature. SettlementIn theory, derivative contracts can be settled in both cash as well as kind. What this means is that the person executing the contract has the right to ask for the delivery of the underlying commodity or the amount of money that’s equal to the value of the underlying commodity. In reality, almost every derivative contract is settled in cash. Asking for delivery of the underlying commodity is not a very usual occurrence in the derivatives market.
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