Market participants can enter into an agreement to exchange money, assets or some other value at some future date based on the underlying asset. Those assets could be commodities, such as gold, stock or even interest rates. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date. For instance, an investor can buy a contract giving him the right to purchase 10 ounces of gold in May for $100 per ounce. If the going price for gold in May is more than $100/oz, then the investor made money on the contract. But if the price is less than, the investor lost money. Until the end of the contract date, however, the price the investor could sell that contract to another investor will fluctuate with the general market’s predictions of what the price of gold in May will be. However, since the futures contract and gold itself trade separately, while the value of the contract is based upon the value of gold, just because gold goes up in price by 10% doesn’t mean the value of the contract will go up the same 10%.
There are many types of financial instruments that are grouped under the term “derivatives”, but options, futures and “swaps” are the most common. The most common type of swaps are interest rate swaps, in which one party agrees to swap cash flows with another. For example, a business may have a fixed-rate loan, while another business may have a variable-rate loan; each of the businesses would prefer to have the other type of loan. Rather than cancel their existing loans the two businesses can agree to “swap” cash flows: the first pays the second based on a floating-rate loan, and the second pays the first based on a fixed-rate loan (in practice, the two will net out the amounts owing). By swapping the cash flow, each has “converted” or “swapped” one type of loan into another. Just as is true in the commodities market, from this basic concept arose a speculative market of betting on outcomes of events or circumstances.
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