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Crypto Explained

Beginners Guide to Derivatives

December 19, 2020
What are derivatives? Derivatives have been around for millennia; their use can be traced back to ancient times when people bartered with one another to trade perishable goods such as grain and livestock[1]. They gained widespread popularity during the rise of the financial services sector, when newer valuation techniques were created in the 1970s and rapidly developed the derivatives market. It is difficult to imagine modern finance without derivatives now.

Derivatives are structured financial products or securities whose value is pegged to an underlying asset, another security, a commodity, or a benchmark such as some particular interest rate. Simply put, derivatives are contracts that enable investors a variety of conduits for price speculation and risk management. Commodities, interest rates, foreign exchange rates, credit, equities and more recently cryptocurrencies, are the most common type of assets on which derivatives are based.

Crypto Derivatives:

 The market for crypto derivatives has grown significantly since the introduction of such products in 2017, with trading volume already multiple times larger than the spot market. Growth in derivatives is often correlated to growing institutional interest in crypto assets, as institutions require opportunities to limit possible losses, hedge against volatility risk and utilize their capital efficiently. Some crypto purists may perceive Bitcoin derivatives as inconsistent with the principles upon which the underlying asset was designed as derivatives by their nature, require exchanges and intermediaries to broker contracts.

Types of Derivatives

Futures:

These are derivative contracts in which the contacted party agrees to purchase or sell off an asset on a particular date at a price agreed upon at the time of the contract. Futures contracts are standardized clearinghouse contracts negotiated in and take place in exchanges.

 Options:

An option derivative is a right given to the buyer of the contract to purchase or sell the underlying asset at a particular price on or before a predetermined date. The buyer has no actual obligation to do so, however.

 Swaps:

These are derivatives contracts that allow for the exchange of cash flows between any two parties at a designated time based on the value of the underlying assets. The most common types of swaps are currency, commodity, and interest rate swaps.

 Uses of Derivatives

Derivatives increase overall market efficiency and liquidity. Derivatives allow investors to hedge against fluctuations in currency values, credit ratings and shifts in interest rates, thereby limiting potential losses and creating opportunities for price speculation. Derivatives also provide investors with access to additional assets and new markets that may have been otherwise unavailable to them.

How to Invest in Derivatives

 Based on their classification, derivatives can either be traded through an exchange, such as EQUOS.io for crypto derivatives, or over-the-counter (OTC). OTC derivatives are customized to an investor’s specific risk and brokered through established financial institutions, for example, investment banks. The counterparty of OTC derivatives are usually large corporations. Exchange traded derivatives are transferred and sold with more ease than OTC derivatives.

 Associated Risks

Traders should assess their own risk-tolerance and inform themselves about the derivatives market before beginning to trade in derivatives.

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