What is a Derivative?
In the world of business and finance, a derivative refers to a form of security which has a value that depends on a particular asset product. If the value of this particular asset changes with the market conditions, so is the value of the derivative. These assets from which the value of the derivative depends on may be in the form of stocks, market indexes, bonds, commodities, currencies, and interest rates. In this sense, a derivative product is simply a by-product of the original product.
When it comes to investing, derivatives are often used for leverage or gearing purposes. In this case, when there is minimal movement on the value of the original product or asset, it may cause a big difference in the derivative’s value. Many investors also use derivatives in hedging risks on the underlying asset or original product. Some use it to help speculate and earn some profit in cases where the value of the original and underlying asset moves to the expected direction. This happens when a person bets on some underlying asset and hopes that the other party seeking insurance will have the wrong guess in terms of the future value of the asset involved. In this way, the investing person will be able to gain from the transaction.
Derivative contracts maybe classified as OTC or over-the-counter derivatives and ETD or exchange-traded derivatives. OTC derivatives refer to contracts that are entered into between two parties directly and privately. The negotiations involved in this type of contract are also kept private and without any involvement from other exchanges and intermediaries. And since the trading transactions are privately held in this type of derivative contract, much of it is unregulated, especially in terms of divulging information between the parties involved. This makes OTC contracts the largest market for derivatives. Exchange-traded contracts meanwhile are those that are traded with derivative exchanges that serve as intermediaries in all transactions. And since these exchanges are in contact with the parties involved, an initial margin is taken from either side which will serve as some form of guarantee.