•   Basics

A derivative is a contract with financial performance that is derived from the performance of "something else." That "something else" is an underlying asset commonly termed "the underlying" and may be another financial instrument, another derivative, or an index of some kind. An example is a call option on a stock (also see the FAQ article on stock option basics). The option is the derivative; the stock is the underlying asset.

How are derivatives used?

Derivatives are generally used to manage the risk of monetary loss or gain. A person or organization can take on additional risk by buying or selling derivatives, or similarly can reduce risk by buying or selling derivatives.
A commonly used example is a grain (i.e., commodity) future. The
contract is the derivative, and the underlying asset is the edible grain such as wheat or corn. A farmer who grows grains can enter into a contract that is an obligation to sell the grain at a fixed price at a date in the future. An investor takes the other side of the contract agreeing to buy the grain at that fixed price for delivery on that future date. The farmer obtains a guarantee he will be able to sell his grain for the agreed price, thus eliminating the risk of the price falling between now and when the crop is ready for delivery. If the grain price falls sharply, the farmer still receives the payment specified in the contract, and the investor loses money. If the grain price rises sharply, again the farmer receives the payment specified in the contract, and the investor may make a profit by reselling the grain at the current, higher price.

How are derivatives traded?

Derivatives may be traded on exchanges or over-the-counter. Exchanges for derivatives include the Chicago Mercantile Exchange (CME) and the London International Financial Futures Exchange (LIFFE). Over-the-counter (or "OTC") derivatives are simply derivative contracts agreed by two counterparties between themselves, without reference to an exchange or any other third party. To reduce the risk of default by either party to a contract, an exchange-traded derivatives contract usually goes through a clearing process whereby a clearinghouse becomes the counterparty to each of the traders rather than each other. The clearinghouse is well capitalized and has rules regarding collateral that must be posted by each trader reflecting the financial performance of that trader's contracts so as to minimize the risk of losses by the clearinghouse. These measures minimize the possibility of a clearinghouse defaulting. Exchange Traded derivatives are standardized contracts. Standardization should improve liquidity but obviously comes at the expense of the ability to customize a transaction to an individual trader抯 requirements. Trading in Over-the-counter derivatives is generally only available to professional investors in the wholesale market. Banks, fund managers, pension funds, insurance companies and hedge funds are active users of the OTC derivatives market.

What are some types of derivatives?

A future or forward contact is an agreement to enter into a financial transaction at a given price on a given date or dates in the future. Such a contract is called a "future" when exchange-traded or a "forward" when over-the-counter. Swap contracts are agreements to exchange one asset or liability for another. The asset or liability is usually a future payment or stream of payments. If it is a foreign currency swap this may entail buying a currency on the spot market and simultaneously selling it forward. If it is an interest rate swap this may involve exchanging income flows; for example, exchanging a stream of fixed rate payments (such as those received from a fixed rate bond) for a variable rate payment stream. Options are the right but NOT the obligation to enter into a pre-arranged financial agreement at a pre-defined price on a future date or dates. As with futures and forwards, options may be either exchange-traded or over-the-counter. There may be conditions that must be fulfilled before the right to enter in to the agreement is conferred. Credit default swaps (which are typically traded OTC) are a good example of this.
In general futures, forwards and swaps have payoff profiles that are linear functions of the performance of the underlying. In derivatives-speak they are said to have approximately constant delta, delta being the percentage change in value of the derivative contract for a 1% change in the price of the underlying instrument. Options, however, will have a payoff profile that is a non-linear function of the value of the underlying instrument. This can make option trading much more complex than trading other derivatives.

For what types of underlying markets are derivatives traded?

A wide variety of derivatives exist. The "underlying" may include the following.
1.Spot foreign exchange. This is the buying and selling of foreign currency at the exchange rates that you see quoted on the news. As these rates change relative to your "home currency" (dollars if you are in the US) you make or lose money.
2.Commodities, like grain discussed in the example above. Others include pork bellies, coffee beans, orange juice, etc.
3.Equities (termed stocks in the US).
4.Government bonds. Bonds are medium to long-term negotiable debt securities issued by national governments. They may generally be freely traded without reference to the issuer of the security, unlike loans. "Short term" is usually defined as being up to 2 years in maturity. "Medium term" is commonly taken to mean from 2 to 5 years in maturity, and "long term" anything above that.
5.Short term ("money market") negotiable debt securities such as T-Bills (issued by governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are much like bonds, differing mainly in their maturity - typically up to 90 days - and in the fact that they are issued at a discount, rather than paying coupons. Derivatives with these as the underlying are available in a few currencies but are relatively rare, with traders preferring Eurodollar or Euribor futures where the underlying are OTC money market borrowing rates (discussed in the next category).
6.Over the Counter ("OTC") money market products such as loans or deposits where the benchmark index is typically LIBOR (the London Interbank Offered Rate) or some other similar index of the rates at which banks are willing to lend to each other. They are known as "over the counter" because each trade is an individual contract between the 2 counterparties making the trade. They are not negotiable securities and therefore cannot in general be freely traded without reference to both original counterparties. In other words if I lend your company money, I cannot trade that loan contract to someone else without your prior consent.
7.Credit risk. A credit default swap (CDS), despite its name, is actually more like an option or insurance contract. In exchange for a stream of premium payments the buyer of a vanilla (or "single issuer") CDS obtains the right to require the CDS seller to purchase bonds of the issuer named in the agreement at a given price (usually 100) IF (and only if) the named issuer incurs a default or other similar "credit event". The market price of these bonds is typically much less than 100 when a default occurs so the CDS buyer will profit and the CDS seller will lose. If the named issuer does not default during the agreed period of the CDS the CDS expires worthless, just as an option would if it was not worth exercising.
8.Indexes. A very wide variety of indexess are used as the underlying for derivative contracts. They may be constructed with reference to financial assets - such as stock market indexes like the Dow ones Industrial Average - or even to temperature or rainfall (in the case of weather derivatives)

Stock index futures, interest rate futures (including deposit futures, bill futures and government bond futures) and commodity futures are the most widely traded futures. Interest rate "forward rate agreements" (FRAs), interest rate swaps (IRS), forward foreign exchange contracts and credit default swaps (CDS) are the most widely traded OTC products.

This FAQ offers many articles about futures and options. Please see those sections.

Derivatives, risk-taking and regulation

In the last few years derivatives and their use by various large institutions became quite a hot topic, especially to regulatory agencies. What really concerns regulators is the fact that big banks swap all kinds of promises - like interest rate swaps, forward currency swaps, options on futures - all the time. They try to balance all these promises (hedging), but there remains a danger that one big player will go bankrupt and leave lots of people holding worthless promises. Such a collapse could cascade, as more and more speculators (banks) cannot meet their obligations because they were counting on the defaulted contract to protect them from losses. This is termed "systemic risk;" i.e., the risk that one default could bring down many other players in the financial system.
Some hedging (risk reduction) with derivatives is done by offsetting an existing position with a related derivative that is strongly correlated with the position to be hedged. An example is selling a stock index future to protect against a loss in a generalized (non sector specific) stock portfolio. Although the stock portfolio may contain a different number of stocks than the stock index and in different proportions, typically we would still expect the index future to move in roughly the same fashion as the portfolio.

However, it's easy for a bank to take accidentally take on too much risk; for example, to hedge bonds with derivatives that don't have the same maturity, same underlying security etc., so that the correlation between the hedge and the risky position is weak, or breaks down in a crisis - exactly when effective hedging is needed most - with potentially big losses as the result. And of course although banks can use derivatives to hedge (reduce) risk, they can also use them as a way of increasing risk to make money. Taking on risk is how a bank makes money; for example, issuing loans is a risk.

As of this update (2009), derivatives are being blamed for many of the financial losses suffered by banks and other financial institutions around the world. Many banks took on so much risk (bought assets that suffered losses) that they collapsed, and taxpayers around the world are being forced to pay huge sums so financial markets keep functioning. New regulations are promised so that use of derivatives is more transparent.

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