Derivatives meaning – Forward, Futures, Option & Swap Explained

What are forwards and options

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  • By Investopedia Staff Updated May 19, An options contract gives an investor the right, but not the obligation, to buy or sell shares at a specific price at any time, as long as the contract is in effect.
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The common underlying assets are stocks, bonds, commodities, currencies, interest rates, etc. It is mostly used for hedging purposes insuring against price risk.

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For example: If you are a farmer producing onions and are concerned about the volatility in the prices of onions, you may enter into a forward contract. The contract will hedge the farmer against the possible decline in prices.

But, for a contract to make sense, it must be beneficial to both parties.

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Arvind must have entered the contract as he thinks that the prices of onion will be greater than Rs. Futures Futures are similar to a forward contract.

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The difference is that futures are standardised agreements to buy or sell an asset in the future at an agreed-upon price. Therefore, they can be traded on stock exchanges.

Buying & Selling Stock

The value of the futures depends on the price of the underlying asset. Futures can be used for hedging or speculation.

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Speculation means buying and selling an asset with the hope of making a profit. A call option gives the holder the right to purchase an asset at an agreed-upon price on or before a specified date.

Options Futures, options and forward contracts belong to a group of financial securities known as derivatives. The profit or loss resulting from trading such securities is directly related to, or derived from, another asset, such as a stock. There are, however, crucial differences between these three derivative securities, which you should understand before investing in them. What Are Options?

This agreed-upon price is known what are forwards and options the exercise price. It has to be noted that the holder has the option and can choose to not buy the asset.

  • Get a free demo Derivatives Derivatives are securities whose value is determined by an underlying asset on which it is based.
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  • Derivatives meaning : Forward, Futures, Option & Swap
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The purchase price of the option is called the premium. It represents the compensation the purchaser of the call option must pay for the right but not the obligation to exercise the option. It will make sense for the call option holder to exercise his option only if the market price of the asset is greater than the exercise price.

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Otherwise, he can buy the asset from the market at a lower price. The call option is the right to buy an asset. Hence, it increases in value, if the price of the asset increases. A put option gives the holder the right to sell an asset at a specified price.

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It will make sense for the put option holder to exercise his option only if the exercise price is greater than the market price of the asset. Otherwise, he can sell the asset in the market at a higher price. The put option is the right to sell an asset. Hence, it decreases in value, if the price of the asset increases.

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Swap A swap is a contract in which two parties exchange their future cash flows for a period of time. The most common type of swap is an interest rate swap.

Types of Derivative Securities Investors are typically acquainted with the popular types of investments like stocks, bonds and mutual funds.

In this, parties agree to exchange interest rate payments. The interest rate will fluctuate.

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Bank B has given out a loan that pays a fixed rate of interest. They can make a contract to exchange their interest inflows. That is all for derivatives.

And many ETFs use a combination of derivatives and assets such as stocks. Derivatives are financial instruments whose price is determined by the price of an underlying asset. The most common derivatives found in exchange-traded funds are futures, which are used particularly often in commodity ETFs so that actual physical commodities don't have to be taken possession of and stored. But ETFs also use forwards, swaps, and options calls and puts.

A participatory note is also a derivative. You may read the following posts from Economyria.