# What are Derivatives?

By [Olamilekan](https://paragraph.com/@olamilekan) · 2022-12-14

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You’ve probably been living under a rock if you’re in the tradfi or crypto space but haven’t come across the term “derivatives”. What exactly are derivatives and what role do they play in the existing financial systems of today’s world?

According to the Merriam-Webster Dictionary, a derivative is a contract or security that derives its value from an underlying asset (or another security) or from the value of a rate (as of interest or currency exchange) or index of asset value (such as a stock index).

![Derivatives 101](https://storage.googleapis.com/papyrus_images/bbd4d50a00185b858df6ad84f73ec5bb2cf64d5f5b770806fd0cf1e91ef10eaa.jpg)

Derivatives 101

How does it work? The buyer and seller enter into a contract to sell such an underlying asset. Such assets are sold at a predetermined time and price. So, the derivatives do not have an inherent value but rely on the value of the underlying asset. For example, an Ethereum derivative relies on and obtains value from the value of Ethereum. They can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings and can be traded on an exchange or over-the-counter. And since they’re usually leveraged instruments, their potential risk/reward is usually high.

The common types include futures contracts, options contracts, and [credit default swaps](https://www.investopedia.com/terms/c/creditdefaultswap.asp).

![Types of Derivatives](https://storage.googleapis.com/papyrus_images/1be008a80846052e12d929c072d5eae48bdbb0c94b0c75a8108f21ef0a2a3d73.jpg)

Types of Derivatives

Derivatives have played quite an important part especially in the crypto space as they help to increase liquidity, mitigate risk and diversify portfolios. Its advantages include but aren’t limited to

*   market efficiency
    
*   low transaction costs
    
*   risk management
    
*   higher leverage
    
*   high liquidity
    
*   diversification
    
    And surely, there are also some disadvantages to it which include;
    
*   higher risk
    
*   regulatory concerns
    
*   lack of due diligence
    
    However, most DeFi derivatives suffer from capital inefficiencies and poor pricing due to the use of order books. Some protocols have tried to make use of AMMs to solve this issue but many of them have still retained the structure of traditional perpetuals which often include a confusing and awkward funding rate mechanism that adjusts for reasons outside of traders’ control over the course of their position. Longship aims to solve this as it is an AMM-based derivatives DEX where traders can execute leveraged long trades on popular crypto indices like ETH and wBTC. Its novel market design is fully DeFi- native and it doesn’t make use of order books, funding rates or off-chain data. Longship team has designed a unique pricing instrument that uses different factors to calculate on-chain prices more easily and efficiently than traditional methods. It offers up to 100x leverage on long positions, guaranteed returns on repurchase agreement trades and an uncapped liquidity pool that functions as an insurance fund. To learn more about Longship, please visit
    
    [https://longship.fi/](https://longship.fi/)
    
    Until the next publish, stay safe frens🤝
    

Article credits: Cointelegraph and Investopedia

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*Originally published on [Olamilekan](https://paragraph.com/@olamilekan/what-are-derivatives)*