¶ … financial derivatives? What are they used for? Types of derivatives. Types of derivatives markets (where are they negotiated).
What are financial derivatives?
Financial derivatives are essentially a financial contract between two people or two entities that depends on the fulfillment of an economic asset in the future, such as a stock, a bond, commodity, or a currency. The two parties make agreements between each other to ensure that all aspects of it will be covered and work in a specific way by a certain date. Financial derivatives, by the way, are called so since the term 'derivative' denotes that their value 'derives' from underlying assets like stocks, bonds and commodities. These financial derivatives can range from something as simple as a private agreement to something that is controlled by rules and restrictions.
Different types of derivatives
There are various derivatives that meet different needs.
Some of these derivatives are the following:
1. A swap:
This is the most common form of derivative. Two parties swap two of their assets that come from different investments in order to balance their respective portfolio and reduce risk. One party, for instance, might want to receive a higher interest from a floating interest rate whilst the other prefers the stability of a fixed interest rate. Each swaps with the other in what is called a "plain vanilla swap." In this way, each gains form the other what the other one wants as way of replacing one asset for another.
This is a simple swap. More complex swaps can involve 'swapping' several different assets in order to protect oneself against risk from various quarters (Milton, A.)
2. Futures
These are financial derivatives that are betting on future events such as investors betting that the stock market as measured by the Standard & Poor's 500-stock index will fall or rise.
Futures are traded on a formal stock exchange and their categories include stock index futures, interest rate futures, and currency futures.
A sub-category of this kind is a 'forward' that is traded outside of a regular exchange. It is an over the counter agreement...
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