Derivatives

A derivative is a financial instrument whose value is based on one or more underlying assets. In practice, it is a contract between two parties that specifies conditions – especially dates, resulting values of the underlying variables, and notional amounts – under which payments are to be made between the parties.

Derivatives are broadly categorized by the relationship between the underlying asset and the derivative, the type of underlying asset, the market in which they trade, and their pay-off profile. The most common types of derivatives are forwards, futures, options, and swaps. Common underlying assets include commodities, stocks, bonds, interest rates, and currencies.

Derivatives are used by investors for the following:

• To provide leverage, a small movement in the underlying value can cause a large difference in the value of the derivative.
  
  
• To speculate and make a profit if the value of the underlying asset moves the way they expect.
  
  
• To hedge or mitigate risk in the underlying by entering into a derivative contract whose value moves in the opposite direction to the underlying position and cancels part or all of it out.
  
  
• To obtain exposure to the underlying where it is impossible to trade in the underlying (e.g., weather derivatives).
  
  
• To create an option ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level).

Using derivatives can result in large losses because of the use of leverage. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. Conversely, investors could lose large amounts if the price of the underlying moves against them significantly.

World Wealth Vs. World Derivatives This graph illustrates total world wealth versus total notional value in derivatives contracts between 1998 and 2007.

Types

In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market.

Over-the-counter (OTC) derivatives are contracts traded (and privately negotiated) directly between two parties without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options – and other exotic derivatives – are almost always traded this way. The OTC derivative market is the largest market for derivatives and is mostly unregulated concerning the disclosure of information between the parties.

Exchange-traded derivative contracts (ETD) are instruments traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts defined by the exchange. It acts as an intermediary to all related transactions and takes the initial margin from both sides of the trade to guarantee the transaction.

Common Derivative Types

A forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

The agreed-upon price is called the delivery price, equal to the forward price when the contract is entered into. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered a profit or loss by the purchasing party.

A futures contract differs from a forward contract in that the former is standardized and written by a clearing house that operates an exchange where the contract can be bought and sold. On the other hand, the latter is non-standardized and written by the parties themselves.

Forwards also typically have no interim partial settlements – or "true-ups" – in margin requirements like futures, so the parties do not exchange additional property, securing the party at a gain, and the entire unrealized gain or loss builds up while the contract is open.

Swaps are derivatives in which counterparties exchange the cash flows of one party's financial instrument for those of the other party's financial instrument. For example, in a swap involving two bonds, the benefits can be the periodic interest (or coupon) payments associated with the bonds.

Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. The swap agreement defines the dates when the cash flows are to be paid and how they are calculated. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price, or commodity price.

Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/options-and-corporate-finance-16/derivatives-120/index.html
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