What is a derivative?
Let’s start by revisiting the definition of derivative products and list some of the most popular ones. A derivative is a financial security. Its value is derived from one or more underlying assets.
A derivative is essentially an agreement between two or more parties based on the previously mentioned assets. The price is determined by the oscillations in the underlying assets. Some of the most common underlying assets – or markets – are indexes, bonds, stock commodities, interest rates and Forex.
There are two ways to trade derivatives, each holding particular characteristics. The most common form of trading derivatives is over-the-counter (OTC). These are largely unregulated and can be considered to be riskier. The other option is to trade through an exchange. This option gives greater security and aims to provide a more organised and consistent experience.
The market risk
Market risk refers to the general risk on an asset or a portfolio to overall market price movements. These so-called movements include inflation, interest rates, currency, and equities.
Traders or investors will try to forecast the performance of a given asset. This forecast is based on their financial analysis, probability or other external factors that influence profitability. From those forecasts they are able to determine the risk/reward ratio of the potential gains versus potential loss.
The time risk
All derivative contracts have a pre-defined duration or expiry date. These contracts expire as soon as the defined duration limit drives them to term. If the investment doesn’t complete the expected goals within the duration limit, this can result in financial losses.