The term derivative refers to a type of financial contract whose value is
dependent on an underlying asset, group of assets, or benchmark. A
derivative is set between two or more parties that can trade on an
exchange or over-the-counter (OTC). These contracts can be used to trade
any number of assets and carry their own risks.
Derivatives are sometimes criticized for being a form of legalized gambling
and for leading to destabilizing speculation, although these points can
generally be refuted. Derivatives are typically priced by forming a hedge
involving the underlying asset and a derivative such that the combination
must pay the risk-free rate and do so for only one derivative price.
Value is derived from the value of one or more underlying, which can be
commodities, precious metals, currency, bonds, stocks, stocks indices, etc.
The four most common examples of derivative instruments are Forwards, Futures,
Options and Swaps.
Futures and options
Futures are derivative financial contracts that obligate the parties to transact
an asset at a predetermined future date and price. The buyer must purchase
or the seller must sell the underlying asset at the set price, regardless of the
current market price at the expiration date. Originally, such trading was
carried on through open outcry and the use of hand signals in trading pits,
located in financial hubs such as New York, Chicago, and London.
Throughout the 21st century, like most other markets, futures exchanges have
become mostly electronic.
Futures contracts can be made or "created" as long as open interest is
increased, unlike other securities that are issued. The size of futures markets
(which usually increase when the stock market outlook is uncertain) is larger
than that of commodity markets, and are a key part of the financial system.
The term option refers to a financial instrument that is based on the value of
underlying securities such as stocks. An options contract offers the buyer the
opportunity to buy or sell—depending on the type of contract they hold—
the underlying asset.
Unlike futures, the holder is not required to buy or sell the asset if they decide
against it. Each contract will have a specific expiration date by which the
holder must exercise their option. The stated price on an option is known as
the strike price. Options are typically bought and sold through online or retail