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are derived from the value of something else (known as the underlying). The
underlying on which a derivative is based can be
an asset (e.g., commodities, equities (stocks), residential
mortgages, commercial real estate, loans, bonds), an index (e.g., interest
rates, exchange rates, stock market indices, consumer price index (CPI) —
see inflation derivatives), or other items (e.g., weather conditions, or other
derivatives). Credit derivatives are based on loans, bonds or other forms of
credit.
Derivatives can be used to mitigate the risk of economic loss arising from
changes in the value of the underlying. This activity is known as hedging.
Alternatively, derivatives can be used by investors to increase the profit
arising if the value of the underlying moves in the direction they expect. This
activity is known as speculation.
Types of derivatives:
Options are contracts that give the owner the right, but not the obligation, to
buy (in the case of a call option) or sell (in the case of a put option) an asset.
Second, the derivatives market helps to transfer risks from those who have
them but may not like them to those who have appetite for them.
Third, derivatives, due to their inherent nature, are linked to the underlying
cash markets.
Sixth, derivatives markets help increase savings and investment in the long
run.
The cash market is a buying strategy in which the buyer makes an
immediate payment that is equal to the current market price for
commodities and other types of securities.
One of the characteristics that sets the cash market apart from a futures
market is this immediate satisfaction and transfer of ownership.
One of the common designations for a cash market is "spot market." Spot
markets get their name from the fact that business deals are initiated and
completed on the spot, rather than requiring an extended period of time to
resolve. Cash markets tend to be somewhat fast paced, since the turnaround
time on a transaction is so short. Many physical commodities are bought and
sold in this type of market.