What is derivative?

In a layman’s language, derivative means profit or loss derived from something. The most common derivative instruments used in financial markets are the forward contract, options, forward rate agreement, futures contract, interest rate swaps etc.  The characteristic and value of these derivative instruments are derived from underlying assets like currencies, Interest rates, stocks indices, precious metals, bonds, and stocks etc.

The derivatives are used to hedge the various types of risks. The investors, who are disinclined to take risk purchase or sell derivatives which may occur due to fluctuations in market price at a future date. The speculators who are ready to take the risk go for buying and selling such derivatives with the hope of making more profit from such deal. In the other words, the derivative transactions actually used to hedge the risks of investors who are risk averse to those who are ready to take the risk to earn more profit.

The meaning of hedge:

Hedging of an asset is an act of risk reduction in order to reduce the potential losses due to adverse price movements in an asset. Normally, an entity hedges the market risk to his assets by using derivatives (call options, put options,  or futures contracts) to offset the future changes in a related security. A hedge may also help the entity to lock in desired profit.

Meaning forward rate agreement (FRA)

A forward rate agreement (FRA) is an over-the-counter contract privately negotiated between two parties that decide the rate of interest, or the currency exchange rate, to be paid or received on an obligation at a forward or future date.

Meaning of Over-the-counter (OTC)

Derivatives are traded in exchange house or over the Counter (OTC). The Over-the-counter (OTC) derivatives are the private agreements between two parties, without going through an exchange or other intermediaries. The popular products like swaps, forward rate agreements, are the examples of OTC.

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