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User guide to Learn Equity and Derivatives

Equity

The term equity can be well-defined by a single word, named 'ownership'. In terms of a publicly traded company, it means same as what common stock or any other security representing an ownership interest mean.

On balance sheet, owner's equity or equity is represented as the difference between total assets and total liabilities of an individual or company (assets minus liabilities). It is said to be increased, when a company making profits, receives more cash for its products than the cost at which it produced these goods. And it is decreased, when decline in the value of asset is registered. Ownership equity is the last or residual claim against assets, paid only after all other creditors, ranked in priority sequence, are paid.

Further, the term can be defined well depending on the context it is used.

Shareholder's Equity: Here, the important clause is that the owners are shareholders. In view of this, shareholder's equity is described as the sum of funds contributed by the owners (the stockholders) and the retained earnings (or losses).

Real Estate Equity: In terms of real estate, an owner refers to his/her equity as the difference between the current value of a property and what the owner owes against that property (mortgage or loan payments on a house). Or simply, it can be termed as the amount, if any, the owner would receive after selling a property and paying off the mortgage. Taken in context of brokerage account, it is the net value of the account.

In Margin Trading, the value of securities in a margin account minus what has been borrowed from the brokerage.

Equity investment:

A methodology of buying and holding shares of stock on a stock market by individuals and funds, in hope to get income from dividends and capital gain when the value of the stock rises, is referred to as equity investment. Investors who can take risk, can look at a limited exposure to equity-oriented instruments for enhancing overall medium-term equity investment returns in medium-term equity investment project. Investment in startup or private (unlisted) company is known as venture capital investment and is generally found to be at higher risk than investment in listed or settled companies.

Equity investments in the form of mutual funds or other pooled investment vehicles are the preferred investment modes for private individuals. Here, there investments are based on the quoted prices given in financial newspapers and magazines. On the contrary, large private investors and institutions prefer to hold shares directly, without the usage of any mutual funds or other investment vehicles.

Derivatives

A derivative is a financial instrument or contract whose value is obtained from the underlying asset's value, interest rates, currency exchange rates, or indices such as stock market index, consumer price index (CPI), and an index of weather conditions. For a hedger or speculator, the main use of derivatives is to either remove risk or take on risk.

Types of Derivatives:

Over-the-counter (OTC) and exchange-traded derivatives

These are two individual groups of derivative contracts, which are distinguished by the way that they are traded in market:

Over-the-counter (OTC) derivatives are traded or negotiated directly between two parties, without going through an exchange or other intermediary. The types of OTC traded in this way are swaps, forward rate agreements, and exotic options. It is difficult to broadcast market price automatically here as there is no exchange to collate and disseminate prices.

Exchange-traded derivatives are those derivatives products that are traded via specialized derivative exchanges, acting as an intermediary to all related transactions and takes initial margin from both sides of the trade to act as a guarantee. Korea Exchange, Eurex, Chicago Mercantile Exchange, and Chicago Board of Trade are recognized as largest derivatives exchange of the world. Derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless, are distinctive. The market price is generally found transparent as it get published in real-time by the exchange, based on all the current bids and offers placed on that contract at any one time.

Common Derivatives:

Three different forms of derivatives fit into the category of common derivatives:

  • Futures/Forwards: Buying and selling of an asset is made at a specified future date in these types of contracts.
  • Options: Options are contracts where one party agrees to pay a fee to another for the right (but not the obligation) to buy something from or sell something to the other at a specified future date.
  • Swaps: Swaps are used when two parties agree to exchange or swap cash flows.

The growth of derivatives in the market continues as they are increasingly used to protect assets from heavy fluctuations and are re-engineered to cover all kinds of risks.


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