Since our last article on DeFi, the total worth of assets locked in various DeFi applications has increased to 40 billion USD. It gives a clear indication of the growing acceptance of the digital economy. From bridging the gap between decentralized economy and traditional finance, DeFi is evolving beyond it to bring us some amazing use-cases. Most DeFi applications have expanded from just simple transactions to hedge the risks of holding any assets or merely simulating them. Most of the interesting DeFi applications revolve around derivatives. As the name suggests, they derive their values from some underlying assets. Traditional derivatives are used to hedge one’s asset price against the other, but derivatives in DeFi allow building synthetic assets as well, with customizable assets within it. To understand the basics of DeFi, please refer to our previous article here. In this article, we will understand the concepts of derivatives in the traditional sense and how they have been maneuvered in the DeFi applications. It will follow a particular emphasis on synthetic assets which is a step further in revolutionizing the finance sector. They bring the possibility of mimicking the payoff of anything of value from the real world in the crypto realm. So let’s check out how speculation has been put to great use with the advent of DeFi. Understanding Derivatives A derivative is a contract between two or more parties whose value is based on an underlying financial asset or a set of assets. It is like secondary financial security with a value derived from the primary security they are linked to, according to the terms of the contract. Common underlying assets are bonds, commodities, currencies, interest rates, stocks, and cryptocurrencies. In decentralized finance, the derivatives are digitized and held as tokens. These are created using smart contracts and the agreement terms are programmatically encoded. This let go need of any third party. It has opened up a new market for investors and created vast opportunities previously restricted to only those with specialized knowledge. So what are actually these derivatives that claim to provide financial security against risks in the market? The financial market is always full of risks, with no correct predictions for the future. Purchase of an asset that seems profitable today may become worthless tomorrow. Or not buying an asset may risk losing profits in case it grows to be a fortune in the future. A derivative is security from this unpredictability and is used to hedge against price changes. Rather than a spot trade, it provides the option to buy or sell an asset at a future date for a price agreed in the present. Its price is derived from the price of the underlying asset it represents. Futures and options are the types of derivatives products generally used. They allow parties to determine the terms of future transactions in the present. Future is a contract between the parties about the price an asset can be bought and sold before an agreed-upon date. Options are another form of derivative contract, which like a future allows parties of a transaction to determine the terms of the future trade in the present along with the flexibility to pull out of the contract in case hedging doesn’t go according to the plan. This ability to walk away from a contract comes at a price called a premium which is to be paid to the other party. Options could be either a call option or a put option. A call option is generally used by the buyer if he thinks that an asset’s price is going to go up. It allows the holder an option to buy or not buy the asset as per the terms decided in the options contract. It provides safety to the buyer if the price doesn’t go up. A put option, on the other hand, provides this flexibility to the seller of the asset. Parties whose business or income is dependent on the stability of an asset price can use derivatives to make sure they are not losing funds. Understand this from an example of a farmer who grows soybean. Its price fluctuates throughout the year pertaining to many reasons. In case the price of soybean is low at the time of harvest, the farmer is looking at a reduction in his profits. To accommodate this risk, the farmer can choose a future or option derivative for the amount that he predicts to harvest. At the time of harvest, if the price of soybean is lower than initially anticipated, the farmer makes a profit from the derivative that offsets the loss from selling the actual soybean. If the price of soybean is higher, the farmer incurs losses from the derivative but profits from actually selling the soybean. So no matter what happens the farmer will end … Continued
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