What is a Derivative?
A derivative is a financial instrument or
agreement whose value is determined (or derived) from the value of
a specified asset, reference rate or index. Derivatives
include futures and options that are actively traded on organized
exchanges. In addition, derivatives include over-the-counter
contracts, such as forwards, options, swaps, swaptions, and
The term "derivative" has also been used to refer to privately
negotiated, specialized transactions. These include debt
instruments that have payoff characteristics reflecting embedded
derivatives, have option characteristics, or are created by
assembling particular components of other instruments such as
principal and interest payments.
Exchange-traded futures and options are the
more traditional, highly standardized contracts that trade on
regulated exchanges. These futures and options provide ready
liquidity, daily pricing and minimal credit risk.
A futures contract is a contract in which a
buyer and seller agree to purchase or sell a given asset at a
specified price on a stated, future date. Both sides of the
trade put up collateral and any change in the value of an
exchange-traded futures contract is settled at the end of each
day. Futures contracts are typically "closed-out" prior to
maturity so that the underlying assets are not delivered.
While financial futures are a relatively modern development,
with trading introduced in 1975, commodity futures have been
trading since the turn of the country. Forward markets for
future delivery of commodities date back to ancient Greece.
An option gives its owner the right, but not
the obligation, to buy or sell an asset, currency, interest rate or
futures contract. The option gives you the right to trade these
underlying securities for a specified price up to a specified
time. If an option is not exercised before the expiration
date of the contract, the option simply expires with no
Options that give you the right to buy the underlying securities
are known as calls. Options that give you the right to sell
the underlying securities are know as puts. Options can be
purchased or sold by the investor.
Over-the-counter (OTC) derivatives are not
traded on formal exchanges and are not standardized; these
contracts are high customized to meet the exact needs of the
user. OTC derivatives can be security-based or
Security-based derivatives are instruments that
are created from other securities such as mortgages and convertible
Contractual derivatives are custom designed
financial arrangements between two parties. Instruments in
this category include currency forwards, swaps and
Both security-based and contractual derivatives can range from
predictable instruments used for hedge or income enhancement
purposes to unpredictable instruments.
A forward contract is a contract in which a
buyer and seller agree to complete a transaction on a given asset
on a specified date at a price specified at the origination of the
contract. The contract owner either receives or makes
payment, depending on the price movement of the underlying
assets. Payment is conveyed only at the
contract's maturity date.
A swap contract involves two parties that agree
to exchange, or swap, specified returns at specified intervals for
a certain period of time. The most common type is an interest
rate swap in which one party agrees to pay a fixed interest rate on
a 'notional' principal amount in return for receiving a floating
rate from the counter-party.
A swaption is the right, but not the
obligation, to enter a swap on preset terms by some future
A structured note is a customized, structure
security created typically with a combination of derivatives and
traditional instruments to meet the specific needs of the buyer and
seller of the note.
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