InÂ finance, aÂ derivativeÂ is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked-called theÂ underlying assetÂ such as aÂ shareÂ or aÂ currency. There are many kinds of derivatives, with the most common beingÂ swaps, futures, andÂ options. Derivatives are a form ofÂ alternative investment.
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For example, aÂ cottonÂ farmer and aÂ millerÂ could sign aÂ futures contractÂ to exchange a definite amount of cash for a certain amount of cotton in the future. Now by doing this both the parties have reduced their risk. The cotton farmer was saved from the price uncertainty and the miller got saved from the unavailability of cotton. However, there are certain situations where still risk is present. There would be no availability of cotton due to vague reasons or the miller couldn’t pay the quantified amount. For these reasons a third party is formed which is called as ‘Clearing House’. Although it sloves most of the future contract but not all the derivated that are insured against counter-party risk. From another perspective, both the farmer and the miller have obtained certain amount of risk and also have lessened certain amount of risk. From the farmers perspective he has lessen the risk that the price of the cotton may drop down and has simultaneously gained the risk if the cotton prices go high. Thinking from the millers’ perspective it has gained the risk if the prices fall down because he might have paid extra from the current prices and it has reduced the risk if the prices go up. Concluding from this situation is that both the parties are under certain type of risk. Speculation and arbitrage Derivatives can be used to obtain risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will get into a derivative contract to gamble on the value of the fundamental asset, betting that the party seeking insurance will be wrong about the future value of the fundamental asset. Speculators will want to buy an asset in the future at a low price according to a contract when the future market price is high, or to sell an asset in the future at a high price according to a contract when the future market price is low. Individuals and institutions may also look forÂ arbitrageÂ opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Derivatives Market The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets.
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