What is a derivative contract and what is it used for?



What is a derivative contract and what is it used for?

 A derivative contract is a contract that exists between two parties whose value is based upon an underlying financial asset or set of assets. Here the buyer agrees to purchase the underlying asset at a specific date at an agreed-upon future price. There are two major classes of derivatives namely, lock and option. In the lock category, the parties have to abide by the agreed-upon terms over the course of the contract. In the option category, the parties have the option to be part of the contract but are not obligated to in any way.

 The following can be the underlying assets which can be used for forming derivative contracts:

  • Interest Rates 
  • Commodities
  • Weather forecasts
  • Stock Indices
  • Currencies
  • Bonds.
The most commonly used derivatives are futures, options, forwards, swaps and warrants. What is surprising is that the seller does not necessarily have to own the asset, instead, he can give the buyer the money to purchase the asset or even offset the contract by giving the buyer another derivative contract.

The derivatives can be traded at two sources: over the counter and standardized exchanges. The volume of over the counter trading is far higher than done at exchanges.

Use of Derivatives:

Most of the top 500 companies in the world use derivatives to lower the risk in their firms. It also helps in more accurate predictability of the share price of a firm (underlying asset whatever it may be).

Derivatives are mostly used in hedging (mitigating risks) and efficient management of fund inflows and outflows. They also help reduce the cost of the investment. Being low-cost financial products and easy to use, they help manage credit risks, liquidity risks, and market risks.


Lastly, it also helps to access unavailable assets or markets since the seller does not have to own the underlying asset. Derivatives, therefore, are great tools for leveraging your portfolio and have sufficient flexibility whether to exercise the right to be part of the contract or not.

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Please comment on any financial query you had like me to address. I will try to post something worthwhile. 

Coming up Next: How to devise a new financial product for your organization?

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