A derivative is a security whose price is dependent upon one or more underlying assets. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Most common forms of derivatives are:
- Forward Contracts
- Futures Contracts
Settled with an intermediary. It is an agreement to trade an asset based on an agreed price. Forward contracts are not traded on an exchange and are settled at the end of the contract.
Settled with a third-party. It is an agreement to trade an asset based upon an agreed price similar to a forward contract. However, future contracts are traded on an exchange and are settled daily.
A contract based upon the assumption that a stock price will rise or fall. There are two main types of options being “Put” or “Call”. If a put option is taken out then money will be made when the price of a stock falls. If a call option is taken out then income will be generated when the price of the stock rises. There is also a straddle option which is a combination of put and call options.
The exchange of one security for another. This could be to change the maturity of a bond, quality of the stocks and/or bonds or because the investment objectives have changed.