### Derivatives

##### Derivative Instruments

(1) A contract, such as an option or futures contract, whose price is derived from the price of the underlying financial asset.

(2) A financial obligation that derives its precise value from the value of one or more other instruments (or assets) at that same point in time

In finance, a Derivative is a financial instrument whose value depends on other, more basic, underlying variables. Such variables can be the price of another financial instrument (the underlying asset), interest rates, volatilities, indices, etc. There are many kinds of derivatives, with the most common being swaps, futures, and options. Derivatives are a form of alternative investment.

A Derivative is not a stand-alone asset, since it has no value of its own. However, more common types of derivatives have been traded on markets before their expiration date as if they were assets. Among the oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.

##### Derivatives are usually broadly categorized by:

- The relationship between the underlying asset and the derivative (e.g., forward, option, swap);
- The type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives);
- The market in which they trade (e.g., exchange-traded or over-the-counter); and
- Their pay-off profile.

##### Derivatives are used by investors to:

- Vanilla derivatives (simple and more common); and
- Exotic derivatives (more complicated and specialized).

##### Another arbitrary distinction is between:

- Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;
- Speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level);
- Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;
- Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);
- Create option ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level).

##### Risk Reduction

Derivatives can be considered as providing a form of insurance in hedging, which is itself a technique that attempts to reduce risk.

Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk.

Derivatives designed for and can serve legitimate business purposes.

We can discuss with you your needs in this area; in particular Risk Mitigation using Derivate Interments in Hedging Portfolio Risk or using them for Enhancing Portfolio Returns.

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