Finance

What is a derivative finance

What is a derivative finance

What is a derivative finance and this is the agreements signed between two parties or more base their value on an underlying financial assets. Financial assets can be called securities. Some examples of underlying financial assets are bonds, shares, interest rate, coupon rates, mortgage payments, stocks and currencies. Some derivatives can also be swapping, future contracts, warrants, stock options and forward contracts.

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FUTURE CONTRACTS

This is a type of derivative that has its value affected by the underlying contract performance.

STOCK OPTIONS

Stock option is also an example or type of derivative that has its value derived from the underlying stock

What is a derivative finance

The value of any derivative is based on or rely on the financial assets given. For example, the derivative stock options has its value depends on the financial assets stock. If you are a derivative owner, it does not mean you are the owner of the financial assets because immediately the loan is paid back, the financial assets goes back to the owner which is debtor. You are just a creditor or business owner who collects the debtor financial assets to serve as a security in case the debtor don’t pay you your money back.

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What is a derivative finance and derivatives between two parties in which an individual provides the commodity to be kept by the other party and serve as insurance. An example is a derivative finance between a farmer and a miller. The two parties may agree on a particular amount of a commodity to be sold after a given period of time regardless of the price of that commodity at that period. This is a risk in which one of the parties gain and the other one loses or the other one gains and one of the parties loses depending on the value of the goods at that period. For example, a farmer who provides 10,000 bushel of wheat to be sold for $3.67 per bushel agrees with the miller on the 10th of January, 2018 that at the end of end of February, 2018, the miller should buy the 10,000 bushel of wheat at that price regardless of the value of the wheat then.

If the value of the wheat should increase which means the price of the wheat in market will also increase and at the end of February, 2018 the price of the wheat per bushel has increased to $4.8. If the calculation is made after the miller has bought the 10,000 bushel of wheat at the amount of $36,000 ($3.67*10,000), the miller gains $1.13 profit per bushel ($4.67 – $3.67=$1.13) which favours the miller when he sells the 10,000 bushel of wheat at the amount of $48,000 ($4.8*10,000). But if otherwise or way round in which the value decreases at that same rate in reverse, the farmer gains $1.13 per bushel of the wheat leaving the miller to lose. You should understand that the losing party does not totally lose, he just lose the extra profit that should have come in for him as the commodity price first given already has a profit rate attached to it before giving it out.

Benefit of derivatives to both sellers and buyers

As earlier explained by the example given above, both the buyer and seller gains depending on the value of the commodity at that particular period. For better clarification, let me give another example. Mr SALVARDORR of SALVARDORR BUSINESS ENTERPRISES just start rearing poultry birds for the purpose of having good sales at the end of six months. But for the fear of bird flu outbreak after a month of rearing, he ran towards Mr Thompson which is an investor in Thompson Poultry Birds Company.

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They have a derivative that after five months if the birds survive the bird flu outbreak, it would be sold at $100 each. After five months when the birds are six months old and ready to be sold but because of the bird flu disease outbreak which is still around, the price of poultry birds are down to $80 per bird. But since Mr SALVARDORR and Mr Thompson had signed a derivative agreement which has put Mr Thompson in the position of buying the birds either the price goes higher or lower. Mr SALVARDORR gains his money on the birds even when there is an outbreak which makes derivative to be beneficial to him and not beneficial to investor.

Also if things are other way round, the investor gain while Mr SALVARDORR loses. So, in above written article it is totally clear that what is a derivative finance and how to implement things related to it in your business and bonds.

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Harish Yadav

Finance and market analyst and chief writer on howtofinance. Passionate to read books and articles on marketing and accounting. Also edits other articles and publish them here.

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