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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 structured notes. 

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 value. 

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 contractual. 

Security-based derivatives are instruments that are created from other securities such as mortgages and convertible bonds. 

Contractual derivatives are custom designed financial arrangements between two parties.  Instruments in this category include currency forwards, swaps and swaptions. 

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 date.

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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bulletTable of Contents 

bulletHow are Derivatives Used? 

bulletIntroduction 

bulletWhat are the Risks? 

bulletExecutive Summary 

bulletSummary 

bulletWhat is a Derivative? 

 

 

 

 

 

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