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Explain about derivatives in finance.
A derivative is a financial instrument which measures the value of an underlying assets. The value is depending on market conditions. Most common derivatives are forwards, futures, options and swaps.
- Derivatives provide leverages.
- Derivatives makes profit.
- Derivatives mitigate risk.
- Derivatives create option ability.
Hedgers, speculators, margin traders and arbitrageurs participates in derivatives market.
Derivative categories are as follows −
- Forward commitments.
- Contingent claims.
Some of the advantages of derivatives are as follows −
- Decrease the risk.
- Market efficiency.
- Diversification of portfolio.
- Price lock.
- Choice of leverage.
Some of the disadvantages of derivatives are as follows −
- High risks.
- More speculations.
- More complicated.
- Hard to value.
- Sensitive to supply and demand factors.
Derivatives used in India are as follows −
Forward contracts − Two parties made an agreement to buy/sell its underlying asset on particular date at an agreed priced in future.
Future contracts − is an agreement to buy or sell an underlying asset at a specific price on a future date.
Option contracts − These contracts does not give obligation to buy or sell an underlying asset. These are sub classified into two types.
Call − Call means the buyer can buy underlying asset at a specific price after entering into contract.
Put − Put means, the buyer can’t sell the underlying asset at a specific price after entering into contract.
Swap contracts − Parties can exchange their cash flows in future with predetermined formula.