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What is a Derivative Contract?

By Edited Nov 9, 2016 0 0

Derivative Contract

Since the recession the term derivative contract has been thrown around constantly by news anchors, politicians and economists. For the average person who has never heard of a derivative contract before it has been frustrating to hear about derivative contracts without knowing what exactly they are. This article should fill in the gap and give you a better understanding as to what a derivative contract is.

Derivative

The technical definition of a derivative contract is a contract whose price is derived from one or more underlying assets. Really, you just need to know that a derivative contract is a special type of contract that comes in 3 forms; a future, an option, or a swap.

 Future

A future is a contract made between two parties to pay for an asset at a set price before the asset is actually claimed. Ultimately the purchaser of the asset is hoping that over time the price of the asset will increase and the seller of the asset is hoping the price will decrease. An example of this would be if John wanted to have 100 pounds of cod for a party in 6 months and wanted to ensure that all 100 pounds would be available at the time of the party. John would go to the local fisherman and propose that he pay the current price of 100 pounds of cod now and in return he would be able to come and claim that 100 pounds of cod anytime in the next 6 months. If the fisherman agrees, then they have entered into a future contract.

Option

An option is a contract made between two parties giving one party the option to either buy (a call option) or sell (a put option) an asset to the other party for a set price over a set period of time. For a call option, the party who has the right to buy the asset is hoping that at some point during the set period of time the price of the asset will be higher than the price that s/he is able to buy it at, and the other party is hoping for the opposite. For a put option, the party who has the right to sell the asset is hoping that at some point during the set period of time the price of the asset will be lower than the price that s/he is able to sell it at, and the other party is hoping for the opposite.

Swap

A swap is a contract made between two parties where one party has a variable exchange rate of some sort (on a loan, bond, ect) and trades the variable exchange rate to the second party in return for a fixed rate. The way that this happens is that the second party will pay or receive the variable rate on the underlying instrument and in pay or receive the agreed upon fixed rate from the first party. If the first party is paying the rate then they are hoping that the variable rate will be higher than the agreed upon fixed rate and the second party is hoping for the opposite. If the first party is receiving the rate then they are hoping that the variable rate will be lower than the agreed upon fixed rate and the second party is hoping for the opposite.

 

Hopefully this article has given you a better understanding of what a derivative contract is.

 

Image by borman818

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