Derivative contracts are financial instruments that allow investors to speculate on the future price movements of underlying assets, such as stocks, bonds, currencies, and commodities. These contracts derive their value from the performance of the underlying asset, and are commonly used for hedging and risk management purposes.
So, how are derivative contracts made? Let`s take a closer look.
Step 1: Determine the underlying asset
The first step in creating a derivative contract is to identify the underlying asset. This could be anything from a single stock to an index of stocks, a commodity like gold or oil, or a currency pair like the euro/dollar exchange rate.
Step 2: Specify the terms of the contract
Once the underlying asset is identified, the terms of the contract must be specified. This includes the contract size, the expiration date, and the strike price.
Contract size refers to the amount of the underlying asset that is covered by the contract. For example, a futures contract for gold might cover 100 troy ounces of gold.
The expiration date is the date on which the contract expires, and the buyer and seller must settle the contract. For example, a futures contract for gold might expire in three months.
The strike price is the price at which the underlying asset can be bought or sold. For example, a call option for Apple stock might have a strike price of $150 per share.
Step 3: Choose the type of derivative contract
Once the terms of the contract are specified, the next step is to choose the type of derivative contract. There are several types of derivative contracts, including futures, options, swaps, and forwards.
Futures contracts are agreements to buy or sell an underlying asset at a predetermined price and date in the future.
Options contracts give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and date in the future.
Swaps are agreements between two parties to exchange cash flows based on the performance of an underlying asset.
Forwards are agreements to buy or sell an underlying asset at a predetermined price and date in the future, similar to futures contracts.
Step 4: Set the price
The final step in creating a derivative contract is to set the price. This is done through a process called « pricing, » which involves estimating the expected future price of the underlying asset based on a variety of factors, such as supply and demand, market trends, and economic indicators.
In conclusion, derivative contracts are complex financial instruments that require a thorough understanding of the underlying asset, contract terms, and pricing methods. By following these steps, investors can create derivative contracts that meet their specific needs and provide valuable opportunities for hedging and risk management.
