Difference Between Derivatives and Equity
What is Equity?
Equity is a form of ownership in the firm and equity holders are known as the ‘owners’ of the firm and its assets. Any company at its stage of a start-up requires some form of capital or equity to begin business operations. Equity is commonly obtained by small organizations through the owner’s contributions, and by larger organizations through the issue of shares. Equity may act as a safety buffer for a firm and a firm should hold enough equity to cover its debt.
The advantage to a firm in obtaining funds through equity is that there are no interest payments to be made as the holder of equity is also an owner of the firm. However, the disadvantage stands that dividend payments made to equity holders are not tax deductible.
What are Derivatives?
Derivatives are special types of financial instruments that derive their value from a number of underlying assets. A derivative will serve as a contract between parties and specifies a number of conditions such as the date at which payments are to be settled. Examples of derivatives include futures, forwards, swaps and options. These derivatives derive their values from a number of underlying assets such as stocks, bonds, commodities (gold, silver, coffee, etc.), various currencies, and fluctuations in interest rates.
Derivatives are used by individuals for speculation and hedging. For example, a trader can enter into a forward contract to purchase 2 million tons of coffee on the 1st October, at a fixed price of $10 per ton. If the price at 1st October is $12 per ton, then the firm would have made a profit (since now they can buy at the lower agreed price) and, if the price turns out to be $9, the firm would make a loss (since now they have agreed to pay a higher price). However, with a forward contract, the price is locked in at $10, and this guarantees that the firm has to pay only $10 regardless of any price fluctuations.
Derivatives vs Equity
• Equity and derivatives are financial instruments that are quite different to each other. The main similarity between the two is that both equity and derivatives can be purchased and sold, and there are active equity and derivative markets for such trade.
• Equity refers to the capital contributed to a business by its owners; which may be through some sort of capital contribution such as the purchase of stock.
• Derivative is a financial instrument that derives its value from the movement/performance of one or many underlying assets.
• The main difference between derivatives and equity is that equity derives its value on market conditions such as demand and supply and company related, economic, political, or other events. Derivatives derive their value from other financial instruments such as bonds, commodities, currencies, etc.
• Certain derivatives also derive their value from equity such as shares and stocks.