Derivatives & Its Types!
A Derivative is a Contract which is usually made to limit or to decrease or to avoid the risk which can be faced by one due to the market fluctuations!
Definition Of A Derivative!
A Derivative is a financial instrument that derives its value from an underlying asset.
I Know You Might Have Not Gotten The Point, YET!
Well, you just don't worry if you didn't get it!
It'll make more sense within a second!
EXAMPLE-
So, let's suppose that there is one "Treasure Box"
Which Is Empty!
So now, what's the value of the key of that "Treasure Box"?
Probably Nothing!
Right?
& NOW If I say that around A Million Dollars In Cash is Available in that same Treasure Box!
Then, NOW what is the value of the same key?
We can confidently say A Million Dollars!
Isn't it?
So, HERE,
The KEY is a Financial Instrument, which have derived its value from the underlying asset & we can say that the underlying asset is the money present within that Treasure Box Or we can say The Treasure Box, itself is the underlying asset.
So I hope that you understood the term "Derivatives"!
Well, now....
Derivatives are of 4 types:
- Forwards
- Futures
- Options
- Swaps
(Forwards & Swaps can't be traded in the Real Market for certain reasons! Where as Futures & Options Can!)
Well, RSPH Blogs - Finances! have articles/blogs which solely talks about Futures & Options. Its not like I am not going to cover about what futures & options really are in this article. I surely will but I won't really cover the entire concept, you know. In fact, this is just a "BASICS" Blog on all the 4 derivatives!
So if you want to know how do futures & options works in reality or if you are willing to start investing in them, then I'll encourage you to go check out :
What Are Futures? (In Derivatives!) (#8)
What Are Options? (In Derivatives!) (#10)
Now let us start understanding all 4 derivatives one by one!
Forwards!
Lets start off with an example-
Let's suppose there is a company named xyz which makes bread.
& we know that the major ingredient required to make bread is "flour".
So let's say that the company xyz purchases flour from a person. Let's call him Mr. X.
So Mr. X delivers flour to the company xyz every 3-4 Months & gets paid whatever the current price of the flour is during that time (at the time of delivery).
Well, if you don't know then I will like to tell you that the flour's price also keeps on fluctuating over time!
So let's say that there are 2 Months to go from now, when Mr. X is supposed to deliver the flour to the Company.
& right now (when there are 2 months to go) the current price of flour is 6$/kg.
& actually what happened last time is that the price of flour falled to 2$/kg & Mr. X had to face a huge loss.
& he just can't let the same thing happen again.
So he made a Forward Contract with the Company xyz.... & this is how it'll benefit both (the Company xyz & Mr. X)....
Well, as per this contract, no matter what the price of flour may be 2 Months later the Company have to buy the flour at the same price which is/was there when this deal (contract) had been made! & that is 6$/kg of flour.
BUT, why will the Company agree with it?
Well, as many chances are there for the flour's price to decrease, as many are there for it to increase.
& the Company just don't wants to pay extra money.
Actually, once the price of flour rised to 10$ & the Company had to pay $4 extra on 1 kg of flour to Mr. X.
& the Company don't want to pay extra money this time. Hence, the Company is also making a profitable deal.
So this have created a WIN! WIN! situation for both! Isn't it?
So this is how basically a forward contract works!
Well, a Forward is a derivative.
Let's see how!?
A Forward derives its value from an underlying asset, which in this case we can say is the flour!
BUT now as of in this entire system we cannot be sure that the Company will buy the floor at $6/kg or not. Because just in case the flour's market price decreased $2/kg then the Company might refuse to pay $6/kg, while it is available for $2/kg.
& we can't be sure about Mr. X, either. Because if the flour price increased to $10/kg in the Real Market then Mr. X may refuse to deliver flour at just $6/kg.
So you know there is nobody guaranting anything. There is no secured system.
But in futures....
Futures!
[Last Forwards Example.... Continued!]
Well, Forwards & Futures are the same!
BUT the only thing which is diffferent among the two is "Security Of The Buyer & The Seller"!
As In Forwards One May Refuse!
In Futures there is a 3rd Party involved which guarantees the security of the buyer & the seller.
The 3rd Party is no stranger but our Regulatory Body. & Stock Exchanges on the other hand pays enough attention to every thing in order to protect one's rights!
So basically the Regulatory Bodies & The Stock Exchanges makes sure that the buyer buys the thing he/she is supposed & the seller sells the thing he/she is supposed to!
If there is somebody/something which guarantees the security of the buyer & the seller in a Forward Contract then it becomes a Future Contract!
If you are interested to know about how futures work in Real Market then I'll for sure suggest you to read the article/blog published by RSPH Blogs - Finances which solely talks about How Futures Works In Real Market?
Options!
Again, starting off with an example....
Let's suppose you want to buy a TV. & the current price of that TV is $1000.
& there is a news you came across which says that the price of that TV may increase to $1500 within a week because taxes may go up & certain prices may be added to it.
So you went to the store & got to know that the TV you currently want is actually out of stock &'ll only be back a week later.
So, what'll you do now?
(I know there are other stores in the city you may go to in reality BUT just to understand Options.... let's continue with this store....)
Ok! So, you went to a worker of the store & told him about this. & after listening to you the worker offers you to book that TV by paying 10% of the entire TV's amount. & because of this deal no matter what the price of the TV maybe a week later, you'll get the TV at the same price you booked it at, which means that while the deal was made.
Hence, no matter what the price of the TV maybe after 1 week. You'll get the TV at $1000.
So its a great deal! Right?
So you payed the booking/premium amount which was 10% (10% of $1000= $100). Hence, you payed $100 to buy this deal OR we can say to buy the RIGHT so that you can buy the TV at $1000 a week later; regardless of what the actual price of the TV may be a week later!
So, Now let's assume it've been a week!
& after a week you came back to the store & got to know that the price of the TV has decreased to $700 from $1000 instead of increasing from $1000.
So, what'll you do now?
You have the RIGHT to buy the TV at $1000 & you've already paid a $100 & you have to pay the remaining $900.
Will you pay it?
Will you use your right?
Ofcourse not! B'coz you are literally facing a loss!
Instead of paying $900 you can literally buy the same TV at $700.
So it'll be better that you buy the TV at $700 & just like kind of forget about the booking of the TV you did to buy it at $1000.
I know you are facing a loss of a $100 you paid to do the booking OR to buy the RIGHT.
But if you continue with that order & pay $900 more THEN you'll face a loss of $300.
Well, we can clearly see the difference & figure out which one's better!
The only loss was the premium paid!
So basically, only loss we can face in options is the premium paid! It kind of limits our losses!
An Option in reality derives its value from a specific company's share/share price. (Like it is mostly traded in that manner & that's also what I know about!)
So this was how BASICALLY Options works!
One always have an option to either use his/her right or not to!
& one only uses his/her right when he/she is making a profit, themselves!
Well, this was just a very basic "options" thing! Now you have an idea & I can confidently say that you'll understand how options actually works in the Real World, very easily. However in reality there are a bunch of more things in options which are different or just were not mentioned in this example of a TV set.
So if any of my readers are willing to know more about Options. Then I'll encourage y'all to go check out our blogs which solely talks & covers almost every topic about How Options Actually Works?
Swaps!
As per of providing the basics of the Swaps. I thought it'll be better if I provide a video.
So here's a youtube video I found of a creater who according to me is really good at explaining stuff. So here it is!
Well, there are Currency Swaps as well. & some other kinds.
So, Stay Tuned if you are interested in Swaps & want to understand about them!
LEAVE A COMMENT if you want me to write an article/blog based on Swaps!
Have I Ever Invested In Any Of The Derivatives, Myself?
NO!
I actually haven't!
I wrote this blog on the basis of my research!
So, any information provided here might not be 100% accurate!
Moreover, I am not recommending anything to anyone here. Anybody who'll invest in Derivatives should invest at their own risk & should take complete responsibilty of it.
I just wanted to make y'all familiar with the concept of OPTIONS!
So, Now you let me know about; What are your views on Derivatives?
Do you think they are profitable?
Will you ever like investing in them?
LEAVE A COMMENT!
&
Thanks For Reading!
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