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What is a derivative?

Derivatives are contracts between a financial reporting company and another party whose overall value is based on an agreed-upon underlying financial asset (e.g. securities) or set of assets. A derivative instrument is a contract that will always be separate from the underlying security.

The most common types of derivatives are call and put options, forward contracts, future contracts, and swaps (interest rate swaps):

As an example, if you purchased a call or put option related to Apple stock, the Apple stock would be the underlying security and the option would be the derivative. The value of the option is only driven by movements in Apple stock.

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  • What is an interest rate swap agreement?

    Basically, each party would swap their contractual rate with the other party because they believe they can get a lower rate in the long-term. For a swap to occur, one party would need a fixed rate and the other would need a floating rate. In an interest rate swap arrangement, both parties would be subject to interest rate risk, market risk, and credit risk. As you can see in the visual below, Simone has the floating rate with her bank and Julia has the fixed rate with her bank. Simone and Julia would swap rates.

  • What is the difference between a put option and a call option?

    A call option gives the investor the option to buy at the strike price, whereas a put option gives the investor the right to sell at the strike price. An investor that buys a call option hopes that the stock price increases in the future while an investor that buys a put option hopes that the stock price decreases in the future.

  • What is the difference between a forward contract and a futures contract?

    Futures agreements are made between a purchaser and a seller and will generally be conducted through a clearing house that allows one party to acquire an investment vehicle at a specific price at a specific point in time at a date that will be determined in the future. Unlike futures contracts, forward contracts are negotiated privately, usually through a third-party broker. Forward contracts are agreements that are reached at a specified point in time that is used to acquire a specific investment vehicle at a later date in time, that is specifically stated in the agreement.