What is it? A derivative is a term for specific types of investments from which payoffs are derived from the performance of eg commodities, shares or bonds, interest rates, exchange rates, or indices. This performance can determine both the amount and the timing of the payoffs. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market.

The Size of the derivatives market is estimated at $300trillion worldwide.

The main types of derivatives are

It’s a standardized contract to buy or sell an underlying asset at a fixed date at a pre-set price. The buying party pays for the right, while the selling party takes on an obligation to deliver. Both parties of a "futures contract" must exercise the contract,

It’s an agreement between two parties to buy or sell an asset at a fixed date at a pre set price. Trade and delivery date are separated. It is used to limit risk. If the transaction is collaterised an exchange of margin will take place. No cash or kind changes hands until the maturity of the contract. Both parties must exercise the contract

c) "Option" gives the holder the right but not the obligation to purchase (a "call option") or sell (a "put option") a specified amount of an underlying asset within a specified time span. The amount changing hands is called the option premium.

d)swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. The cash flows are calculated over a fixed principal amount. Swaps are often used to hedge certain risks, for instance interest rate risk.

(eg fixed interest into floating interest) Another use can be speculation.

Swaps are negotiated outside exchanges. They cannot be traded as they are unique. The only way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a third party. This latter option is only possible with the consent of the counterparty.

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

Over-the-counter (OTC) derivatives

contracts traded directly between two parties, without going through an intermediary Products like forward rate agreements or exotic options are traded in this way.

Exotic options are more complex than commonly traded products (called vanilla options). An exotic option may have one or more of the following features:

The payoff at maturity depends not just on the value of the underlying asset at maturity, but of the value at several times during the contract's life It could depend on more than one index There could be callability and putability rights. It could involve foreign exchange rates in various ways etc..

Exotic options can pose challenging problems in valuation and hedging.

Exchange-traded derivatives

are derivatives traded via derivatives exchanges. Here the exchange acts as an intermediary and takes initial margins from both sides of the trade.

The difference to OTC is that there is no direct link between the parties, but the exchange is playing the counterpart role.

The most used derivatives are

Economic derivatives

pay off according to economic reports as measured and reported by national statistical agencies

Energy derivatives

pay off according to a wide variety of indexed energy prices. They are classified as either physical or financial. Physical derivatives include the obligation to actual delivery of the underlying energy commodity, whatever this may be

The three main applications for the energy derivative markets include are

Risk Management, Speculation ("Trading"), Investment Portfolio Diversification

Freight derivatives

they represent trading in future levels of freight rates, primarily for dry bulk carriers and tankers. They include exchange traded futures and options as well as freight forward contracts. They are Used by shipowners and operators, oil companies, trading companies and grain houses as tools for managing freight market risks

Insurance derivatives (compare insurance)

Weather derivatives

can be used by organisations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. Here the underlying asset rain/temperature/snow has no direct value. Farmers can use weather derivatives to hedge against poor harvests caused by drought or frost, theme parks may want to insure against rainy weekends during peak summer seasons, and gas and power companies may use heating degree days (HDD) or cooling degree days (CDD) contracts to smooth earnings.

Credit derivatives

transfers credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default options, credit limited notes and total return swaps.

Cash flow in derivatives

The payments between the parties may be determined by:

the price of some other, independently traded asset in the future

or the level of an independently determined index

the occurrence of some well-specified event (e.g., a company defaulting);

an interest rate; an exchange rate; or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise he looses.

The potential gain or loss on a derivative can be much higher than if the underlying security or commodity would have been traded directly.

Determining the market price

For exchange traded derivatives, market price is usually transparent. Complications can arise with OTC or floor-traded contracts, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.

Controversy

There have been several instances of massive losses in derivative markets. These events include the largest municipal bankruptcy in U.S. history, in 1994, and the bankruptcy of Long Term Capital Management.

Because derivatives offer the possibility of large rewards, many individuals have the strong desire to invest in derivatives. Most financial planners caution against this, pointing out that an investor in derivatives often assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small investor One should keep in mind that one purpose of derivatives is as a form of insurance, to move risk from someone who cannot afford a major loss to someone who could absorb the loss, or is able to hedge against the risk by buying some other derivative.

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