Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, currencies or interest rates. There are two main types of derivatives - over-the-counter (OTC) derivatives like swaps that are privately negotiated between two parties, and exchange-traded derivatives that are traded on specialized exchanges. Common derivative contracts include forwards, futures, options, and swaps. While derivatives are often used to hedge risk, they can also be used for speculative purposes.

1. Derivatives
A derivative is a financial contract which derives its value from the performance of another entity
such as an asset, index, or interest rate, called the "underlying".
It is a security whose price is dependent upon or derived from one or more underlying assets. The
derivative itself is merely a contract between two or more parties. Its value is determined by
fluctuations in the underlying asset. The most common underlying assets include stocks, bonds,
commodities, currencies, interest rates and market indexes. Most derivatives are characterized by
high leverage.
Futures contracts, forward contracts, options and swaps are the most common types of derivatives.
Derivatives are contracts and can be used as an underlying asset. There are even derivatives based
on weather data, such as the amount of rain or the number of sunny days in a particular region.
Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative
purposes. For example, a European investor purchasing shares of an American company off of an
American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while
holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a
specified exchange rate for the future stock sale and currency conversion back into Euros.
Derivatives are a contract between two parties that specify conditions (especially the dates, resulting
values and definitions of the underlying variables, the parties' contractual obligations, and
the notional amount) under which payments are to be made between the parties. The most
common underlying assets include commodities, stocks, bonds, interest rates and currencies, but
can also be other derivatives, which adds another layer of complexity to proper valuation.
There are two groups of derivative contracts: the privately traded over-the-counter (OTC)
derivatives such as swaps that do not go through an exchange or other intermediary, and exchange-
traded derivatives (ETD) that are traded through specialized derivatives exchanges or other
exchanges.
(Over-the-counter (OTC) or off-exchange trading is done directly between two parties, without any
supervision of an exchange. It is contrasted with exchange trading, which occurs via these facilities.
An exchange has the benefit of facilitating liquidity, mitigates all credit risk concerning the default of
one party in the transaction, provides transparency, and maintains the current market price. In an
OTC trade, the price is not necessarily made public information.)
 Over-the-counter (OTC) derivatives are contracts that are 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 in this way. The OTC derivative market is the largest market for derivatives,
and is largely unregulated with respect to disclosure of information between the parties, since the
OTC market is made up of banks and other highly sophisticated parties, such as hedge funds.
Reporting of OTC amounts is difficult because trades can occur in private, without activity being
visible on any exchange.
 Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via
specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where

2. individuals trade standardized contracts that have been defined by the exchange. A derivatives
exchange acts as an intermediary to all related transactions, and takes initial margin from both
sides of the trade to act as a guarantee.
( The world's largest[26] derivatives exchanges (by number of transactions) are the Korea
Exchange (which lists KOSPI Index Futures & Options),Eurex (which lists a wide range of European
products such as interest rate & index products), and CME Group (made up of the 2007 merger of
the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of
the New York Mercantile Exchange).
Types of Derivatives
1. Forwards: A tailored contract between two parties, where payment takes place at a specific
time in the future at today's pre-determined price.
2. Futures: are contracts to buy or sell an asset on or before a future date at a price specified
today. A futures contract differs from a forward contract in that the futures contract is a
standardized contract written by a clearing house that operates an exchange where the
contract can be bought and sold; the forward contract is a non-standardized contract written
by the parties themselves.
(An organization associated with an exchange to handle the confirmation, settlement and
delivery of transactions, fulfilling the main obligation of ensuring transactions are made in a
prompt and efficient manner. They are also referred to as "clearing firms" or "clearing
houses".)
3. Options are contracts that give the owner the right, but not the obligation, to buy (in the case
of a call option) or sell (in the case of a put option) an asset. The price at which the sale
takes place is known as the strike price, and is specified at the time the parties enter into
the option. The option contract also specifies a maturity date. In the case of a European
option, the owner has the right to require the sale to take place on (but not before) the
maturity date; in the case of an American option, the owner can require the sale to take place
at any time up to the maturity date. If the owner of the contract exercises this right, the
counter-party has the obligation to carry out the transaction. Options are of two types: call
option and put option. The buyer of a Call option has a right to buy a certain quantity of the
underlying asset, at a specified price on or before a given date in the future, he however has
no obligation whatsoever to carry out this right. Similarly, the seller of a Put option has the
right to sell a certain quantity of an underlying asset, at a specified price on or before a given
date in the future, he however has no obligation whatsoever to carry out this right.
4. Swaps are contracts to exchange cash (flows) on or before a specified future date based on
the underlying value of currencies exchange rates, bonds/interest rates, commodities
exchange, stocks or other assets. Another term which is commonly associated to Swap
is Swaption which is basically an option on the forward Swap. Similar to a Call and Put
option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one
hand, in case of a receiver Swaption there is an option wherein you can receive fixed and

3. pay floating, a payer swaption on the other hand is an option to pay fixed and receive
floating.
Swaps can basically be categorized into two types:
Interest rate swap: These basically necessitate swapping only interest associated cash
flows in the same currency, between two parties.
Currency swap: In this kind of swapping, the cash flow between the two parties includes
both principal and interest. Also, the money which is being swapped is in different currency
for both parties.