Characteristically, derivatives have one advantage over stocks and bonds even though at higher price volatility (and hence higher risk). The high leverage of derivatives can result in greater profits, but that comes with the cost of increased risk, which may be translated, if things don’t go well, into greater losses. Leverage in derivatives mainly come from three sources: futures leverage, option leverage, and swap leverage. The following table enlists the most popular notional leverage instruments:
| Exchange-traded Options | Exchanged-traded instruments that give the holder the right, without the obligation, to buy or sell a specific asset at or by a preset time (expiration date) at a predetermined price (exercise price) |
|---|---|
| OTC Options | Instruments that are traded over the counter (i.e., tailor-made and traded directly between counterparties and according to their own conditions and requirements). Examples include: swaptions (options on swaps), caps, floors, collars, etc.
The amount on which these instruments are typically based is known as the notional value. |
| Forward Contracts | Over-the-counter instruments that provide exposure to a wide array of assets such as stocks, bonds, currencies, commodities, etc. These contracts are not traded on exchanges and hence their elements (quantity, delivery, expiration, etc) are usually defined by transacting counterparties. |
| Futures Contracts | Exchange-traded instruments that provide exposure to a variety of assets such as equity, fixed-income securities, currencies, commodities, etc. Counterparties to a futures contract have to deposit margin (it is relatively a small fraction of the contract value). |
| Swaps | Over-the-counter agreements that entail the exchange of two types of cash flows according to terms negotiated among the counterparties. |
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