In accounting and finance, a derivative refers to a contract that derives value from another underlying variable. Essentially, derivatives create a hedging mechanism that insulates you from risks over which you have little or no control. However, investors also use derivatives to realize yield or make a profit. Common types of derivatives include forwards, futures, options, swaps, caps, floors, collars and swaptions.
A derivative is a financial instrument or contract with three important characteristics. First, a derivative has one or more terms and one or more notional amounts or payment provisions that determine the amount of the settlement. Additionally, derivatives require only a small initial net investment. Finally, derivatives allow net settlement. Net settlement means you can readily settle derivatives using capital outside the contract.
Purchasing derivatives can help your company minimize certain risks. Types and applications of derivatives differ depending on the specific nature of risks your company faces. For example, the interest rate risk is the risk of changes in interest rates. Foreign exchange risk regards exchange rate fluctuations, and commodity risks can cause changes in commodity prices. Other risks faced by businesses include risks on capital market instruments, credit risks and weather risks. Derivatives can help protect a business from these risks.
Forwards and Futures
A forward is a type of derivative defined as a contract to buy a security or commodity at a prefixed future date. A forward derivative is either used for hedging or speculation. Another type of derivative is a future, the more standardized form of a forward contract. You can trade futures through exchanges. Therefore, most futures contracts are highly uniform and specify all the details of the contract. When comparing forwards and futures, forward contracts have the credit risk element.
Options, Swaps, Caps, Floors, Collars and Swaptions
Unlike a future, an option provides the contracting party an option to buy or sell a security or financial instrument at a prefixed price in the future. This differs from a future because a future is an actual obligation. In a swap, both parties exchange recurring payments to exchange one stream of payments for another -- for example, swapping fixed interest rates with floating interest rates. Caps, floors and collars are types of options that enable you to shift the risk of an upward or downward movement in variables such as interest rates. A swaption is an option on a swap and has the characteristics of both an option and a swap.