A derivative can be defined as a complex financial contract, the value of which depends on an underlying asset or a group of assets.
The contract is set between two participant parties and is used by traders to access specific markets or trade assets. Underlying assets for derivatives can comprise commodities, bonds, stocks, currencies, market indexes, and interest rates.
The value of the derivative depends on the fluctuation in the value of the underlying assets.
Traders can use derivatives to hedge on a market position, give leverage to specific holdings, or speculate on the movement of an underlying asset.
They are usually traded on derivatives exchanges or over-the-counter (OTC) and purchased through brokerage firms. DeFi protocols are starting to offer similar products as well.
Over-the-counter derivatives have an enhanced possibility of counterparty risk. Counterparty risk could occur when one of the two parties involved could default since the contract is unregulated.
Derivatives today are based on a host of different transactions and have several uses, with some based on weather data or the amount of rain a particular region could receive. The most common types of derivatives are Futures, Swaps, Forwards, and Options.
Derivatives are a valuable tool for investors and have several advantages, some of which are
- It can be used to hedge against unfavorable price movements
- Helps to mitigate risk
- Lock in prices.