Difference between Derivatives and Equity

Equity and derivatives are financial instruments which hold different implications for an individual or firm. Equity is simply the share of claim, interest or ownership in a business or asset. The holder of an equity becomes the owner of the firm and its assets, where his money will be utilized for expansion or growth purposes. A person can simply invest in a business by injecting money or buying shares or stocks.

Derivatives on the other hand, are a special branch of financial instruments that derive their value from an underlying asset, index or interest rate. Here the participants enter in a financial contract, and the overall returns will be affected by market changes which account for adjustments in interest rates and currency exchanges.

Differences in the two concepts can be better understood if we compare shares (equity) with derivatives, which can take the form of stock options, swaps, futures, floors etc. In equity, you are relying on the performance of the company, where a share will appreciate in value when the company returns are profitable. In derivatives, you have entered in a contract, where you agree to purchase a certain amount at a specific price in the future (this can vary depending on the agreement). If for instance, you agree to buy 2 million shares at $10 after two months, and the share price increases by $2, then you have profited $2 million. Therefore, derivatives give investors greater leverage to adjust their returns by accounting for market changes.

However, with greater leverage, derivatives come with greater risk as well. If the price of the above share drops to $8, then you would lost $2 million as you had already agreed to purchase each stock at $10. While you are hedging against losses and risks, chances are that your future speculation may not be appropriate.

While equity always deals with an individual and his or her investment strategies which can take capital or stock form, derivatives cover all sorts of securities such as bond, stocks and commodities.

Instructions

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    Derivatives

    It is a special financial contract between two parties, the value of which is derived from an underlying asset, index or security. Derivatives are a way for investors to mitigate risk, create options, get exposure and speculate in order to make profitable returns.

    Image courtesy:  referenceforbusiness.com

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    Equity

    It is an investment strategy which represents interest, claim or direction ownership in a firm or its assets.

    Image courtesy: equity-tips-calls.blogspot.com

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