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Traditional and derivative instruments

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What are the differences between traditional and derivative instruments?
Why do companies use derivative instruments? Are derivatives a good
investment? Why or why not?

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What are the differences between traditional and derivative instruments?

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A traditional financial instrument is a trading security equity (stock) or debt (bond). A derivative financial instrument is different as it must have three characteristics.

The instrument has (a) one or more underlyings and (b) an identified payment provision. An underlying is a specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable. Payment is determined by the interaction of the underlying with the face amount or number of shares, or other units specified in the derivative contract. For example, the university purchased a call option when ABC Inc. shares are trading at $100 per share. The contract gives the university the option to purchase 1,000 shares of ABC Inc. at an option price of $100 per share and expires in 120 days. When the stock ...

Solution provided by:
Sandeep Bardia, MBA
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  • BCom, SGTB Khalsa College, University of Delhi
  • MBA, Rochester Institute of Technology
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