Financial derivatives are contracts that derive their value from the price movements of an underlying asset, such as a stock, bond, commodity, or currency. Derivatives can be used for hedging, speculation, or arbitrage purposes.
There are several types of financial derivatives, including futures contracts, options contracts, swaps, and forwards. Futures contracts obligate the buyer and seller to buy or sell the underlying asset at a specified price and date in the future. Options contracts give the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price and date in the future. Swaps are agreements to exchange cash flows based on a set of predetermined conditions. Forwards are similar to futures contracts, but are customized agreements between two parties and do not trade on exchanges.
Derivatives can be used to hedge against price risks, such as changes in interest rates, commodity prices, or exchange rates. They can also be used for speculation, where investors bet on the direction of price movements in the underlying asset. Derivatives can be complex and can carry significant risks, including the potential for large losses if the underlying asset does not move in the expected direction. As a result, derivatives are typically used by sophisticated investors and financial institutions.
