Securities that derive their value from other financial instruments are known as Derivatives. The financial instrument can be an equity stock. In other words, A Derivative is a financial instrument that is derived from some other asset, index, event, value or condition. The derivatives are widely used by the insurance companies to hedge its bets on which direction the market is moving. Derivative instruments are used as financial management tools to enhance investment returns and to manage such risks relative to interest rates, exchange rates, and financial instrument and commodity prices.
There are different types of derivatives such as:
Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts, such as futures of the NASDAQ.
Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him. Options are of two types - Calls and Puts options:
‘Calls’ give the buyer the right but not the obligations to buy a given quantity of the underlying asset, at a given price on or before a given future date.
‘Puts’ give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date.
Thus Derivatives plays a major role in the equity investments.
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