What are derivative contracts? These are contracts between two or more parties where the derivative value is based upon an underlying financial asset or a set of assets.

What Is a Derivative Contract?

Underlying instruments may be the following:

  • Stocks
  • Bonds
  • Commodities
  • Interest rates
  • Market indexes
  • Currencies

Fluctuations in the underlying asset determine the price of the derivative. People may trade derivatives on an exchange or over the counter (OTC).

OTC derivatives are more common, and they're unregulated. They usually carry more risk for the counterparty. Derivatives that are traded on exchanges are standardized, and they come with less risk.

Originally, people used derivatives to ensure balanced exchange rates in the trade of international goods. International traders needed a reliable accounting system because national currencies had such differing values.

Today, there are many more uses for derivatives, and they're based on a wide variety of transactions. Some derivatives are even based on weather data, such as the number of sunny days a particular area will have.

A derivative isn't a specific kind of security; instead, it's a category of security. Therefore, several types exist. Depending on the type, a derivative will have different functions and applications. For example, certain types of derivatives are used for hedging or insuring against an asset's risk. In addition, high leverage characterizes many derivatives.

One example of a derivative is a stock option because the value is "derived" from the underlying stock. Although assets determine a derivative's value, owning the derivative doesn't equate to owning the asset.

Common Types of Derivative Contracts

Common derivatives include the following:

  • Forward contracts
  • Futures contracts
  • Warrants
  • Options
  • Swaps

Futures contracts are derivatives because their value is affected by the underlying contract's performance. These are one of the most common derivatives. Futures contracts may be known simply as “futures,” and they're agreements for the sale of a particular asset for an agreed-upon price. In general, a person uses a futures contract during a set period of time to hedge against risk.

Forward contracts are like futures contracts, but the main difference in "forwards" (as they're often called) is that they're traded over the counter, not on exchange.

When two parties agree to trade loan terms, this contract is known as a swap. A person may use an interest rate swap in order to switch from a fixed interest rate loan to a variable interest rate, or vice versa.

Say someone has a variable interest rate loan and wishes to secure additional financing from a lender. The lender may deny the loan due to the uncertain future of the individual's ability to repay the loan based on the variability of the interest rates. The lender may fear a default on the loan.

For that reason, the person may want to switch the variable interest rate loan with another party, who has a fixed rate loan that's otherwise similar. The loans remain in the names of the original holders, but the agreement stipulates that each party makes payments toward the other party's loan. This comes with some risks if one party goes bankrupt or defaults. The other party will then be forced back into the original loan.

People can make swaps with the following:

  • Currencies
  • Interest rates
  • Commodities

Options are similar to futures contracts because they're agreements where one party presents another party with the chance to buy or sell a security at an agreed-upon future date. The main difference between futures and options is that in an option, the buyer has no obligation to follow through with the transaction if he or she chooses not to. Ultimately, the exchange is optional.

Options may be long or short. They may also be a call or put. Retail traders commonly use options as a derivative type because they can trade them easily on most large equities.

Mortgage-backed securities are another common type of derivative. In this broad category, the underlying assets are mortgages.

Derivative contracts are agreements that all parties are expected to adhere to. You may want to consult with a legal and/or financial expert when looking into these types of contracts, since it's always important to fully understand the terms and conditions in the agreement before you sign.

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