Derivatives are financial products whose values are derived from an underlying financial product. A derivative trade is a contract containing specific terms between one party and its counterparty; in the world of derivatives, the terms ‘trade’ and ‘contract’ are synonymous.
The particular characteristic that makes the buying and selling of derivatives distinct from buying and selling underlying financial products (e.g. equity or bond), is the following:
- purchasing an equity or bond requires the buyer to pay 100% of its market value, and selling an equity or bond means the seller will receive 100% of its market value
- purchasing a derivative (for example, where the underlying product is an equity or bond) requires the buyer to pay a fraction (e.g. 10%) of the market value of that underlying product.
Investing in a derivative provides access to an underlying product, but at a fraction of the cost. Providing the value of the underlying investment increases, the derivative investor’s profits can be magnified greatly. Conversely, if the underlying investment decreases in value, the derivative investor ...