Financial derivatives are securities where the price derives from the underlying asset, explains Investopedia. Derivatives are a contract between parties where fluctuations in the underlying assets determine the contract’s value.
Interest rates, stocks, bonds, commodities and market indexes are common forms of underlying assets, claims Investopedia. Investors trade financial derivatives on over-the-counter markets or on major market exchanges. Financial derivatives are a category of a security rather than an individual security; therefore, investors can hedge their trades or insure their derivative trades against risk on an asset. Investors also use derivatives to speculate on the future prices of the underlying assets.
The most common types of derivatives are futures contracts, according to Investopedia. Futures contracts are agreements between two parties to sell an asset at an agreed-upon price in the future. Investors usually use futures contracts to hedge against risk during a specified period of time. Forward contracts are another form of financial derivatives. Forward contracts do not trade on major market exchanges but do trade on over-the-counter markets. Swaps are another common form of financial derivatives. Swaps are usually contracts between two parties where they agree to trade the loan terms of an underlying asset. Some derivatives traders use interest rate swaps to switch from fixed interest rates to variable interest rates.