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Reviewed by Mar 01, 2023| Updated on
A financial security with a value derived from an underlying asset or a group of assets—a benchmark - is called a derivative. It is a contract between two or more parties, and the price is determined by variations in the underlying asset.
Assets like stocks, bonds, commodities, interest rates, currencies and market indexes can be derivatives. These assets are purchased through brokerages and can trade over-the-counter or through an exchange.
OTC derivatives make for a significant proportion of the derivatives market and have a greater possibility of counterparty risk. This means that the parties in the transaction can default.
Derivatives can be applied to identify the directional movement of an underlying asset, hedge a position, r, or even give leverage to holdings. Their value arises from the variations of the values of the underlying asset. Originally, derivatives were used to secure balanced exchange rates for goods traded globally. With the varying values of national currencies, international traders wanted a system to account for differences. Today, derivatives are based on a broad variety of transactions.
Derivatives can be a valuable tool for businesses and investors. They present a way to lock in prices, hedge against unfavourable movements in rates, and mitigate risks—usually for a limited cost. Besides, derivatives can usually be obtained on margin—that is, with borrowed funds—which makes them less expensive.
Common examples of derivatives involve futures contracts, options contracts, and credit default swaps. Surpassing these, there is a vast quantity of derivative contracts tailored to meet the requirements of a diverse range of counterparties. Since several derivatives are traded over the counter, they can be infinitely customised..