Understanding Derivative Contracts

Financial Derivatives are contracts or agreements between two or more parties that stipulate the transfer of one legal obligation or asset to another party. The basis of this transfer is financial instruments such as stocks, bonds, derivatives, forward contracts, swaps, other financial investments, interest rates, and the index futures market. Financial derivatives are a key feature of international finance and the exchange of currencies. Derivatives are grouped into three major categories: equity derivatives, credit derivatives, and financial derivatives.

Description from Harbourfront Technologies: Derivative is a financial product whose value is based on the values of one or more underlying financial commodities or indexes. This underlying asset can be a financial instrument itself, such as bonds, stocks, financial securities, and the like, and is most often just called the underlying. It may also be a company, trust, commodity, contract, or the like. Financial derivatives are complex financial products that rely on complex mathematical models to ensure that losses or profits are distributed to all participants in the contract in an optimal situation, but also to ensure that losses and profits are appropriately distributed between those participants in the contract.

Example of a Financial Derivative: The derivative known as the equity derivative is an agreement or contract under which two parties agree to buy or sell their shares of stock, at a later date, for a pre-determined price. The price will be established by the underlying company or index. Under these circumstances, when the price reached by the two parties is higher than the value of the underlying shares, a profit is declared by the company or the index and the buyer or seller of the shares gets the added benefit of the higher price. In this example, both the buyer and seller of the shares gain profit, with the buyer more so than the seller. This transaction is an equity derivative based upon how are swaps taxed.

The different types of derivatives are not limited to financial instruments. For example, trade bonds and mutual funds are derivatives that have been popular in the past, although not as popular today. There are many more financial derivatives that fall under the commerce or financial instruments category. Some of the most common financial derivatives contracts are currency derivatives, interest rate derivatives, and commodity derivatives. Each type has specific uses.

Derivatives also include financial derivatives that relate to the underlying asset. They may be long or short. Long financial derivatives are trade bonds that are sold for a period of time and later get purchased by the issuing party, for a pre-determined price. Short financial derivatives are trade bonds that get purchased and sold by the buying party. Both types of the derivative have a maturity date.

Today, a lot of money is being transacted through financial derivatives trading. This is because the Internet allows faster transactions and the transfer of funds from one place to another very easily. The Internet also makes it easy for people to learn about financial derivatives trading. A lot of new trading platforms are available for traders to use. You should always research the different trading platforms before getting involved with derivatives trading.


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