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In finance, derivatives is the collective name used for a broad class of financial instruments that
derive their value from other financial instruments ;known as the underlying, events or
conditions.

Derivatives are usually broadly categorised by the:

up melationship between the underlying and the derivative e.g.forward contract, option,
swap finance
up Êype of underlying e.g. equity derivatives,foreign exchange derivatives, interest rate
derivatives, commodity derivatives or credit derivative
up „arket in which they trade e.g., exchange traded or Over-the-counter finance over-the-
counter

up ay-off profile Some derivatives have non-linear payoff diagrams due to embedded
optionality

Derivatives allow risk about the price of the underlying asset to be transferred from one party
to another. For example, a wheat farmer and a miller could sign a futures contract to exchange
a specified amount of cash for a specified amount of wheat in the future. Both parties have
reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the
availability of wheat. However, there is still the risk that no wheat will be available because of
events unspecified by the contract, like the weather, or that one party will renege on the
contract. Although a third party, called a [[clearing house (finance)|clearing house]], insures a
futures contract, not all derivatives are insured against counterparty risk.

$#%&
Êhe right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific
amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike
price) during a specified period of time. For stock options, the amount is usually 100 shares.
Each option contract has a buyer, called the holder, and a seller, known as the writer. If the
option contract is exercised, the writer is responsible for fulfilling the terms of the contract by
delivering the shares to the appropriate party. In the case of a security that cannot be delivered
such as an index, the contract is settled in cash. For the holder, the potential loss is limited to
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the price paid to acquire the option. When an option is not exercised, it expires. No shares
change hands and the money spent to purchase the option is lost. For the buyer, the upside is
unlimited. Option contracts, like stocks, are therefore said to have an asymmetrical payoff
pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning
that the writer already owns the security underlying the option. Option contracts are most
frequently as either leverage or protection. As leverage, options allow the holder to control
equity in a limited capacity for a fraction of what the shares would cost. Êhe difference can be
invested elsewhere until the option is exercised. As protection, options can guard against price
fluctuations in the near term because they provide the right acquire the underlying stock at a
fixed price for a limited time. misk is limited to the option premium (except when writing
options for a security that is not already owned). However, the costs of trading options
(including both commissions and the bid/ask spread) is higher on a percentage basis than
trading the underlying stock. In addition, options are very complex and require a great deal of
observation and maintenance. Also called option.

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Êhe primary types of financial options are(p

up Exchange traded options (also called "listed options") are a class of exchange traded
derivatives.

up Over-the-counter options (OÊ options, also called "dealer options") are traded
between two private parties, and are not listed on an exchange.
up Employee stock options are issued by a company to its employees as compensation.

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In finance, a swap is a derivative in which two counterparty trade certain benefits of one party's
financial instrument for those of the other party's financial instrument. Êhe benefits in
question depend on the type of financial instruments involved. Specifically, the two
counterparties agree to exchange one stream of cash flows against another stream. Êhese
streams are called the legs of the swap. swaps can be used to create unfunded exposures to an
underlying asset, since counterparties can earn the profit or loss from movements in price
without having to post the notional amount in cash or collateral. If firms in separate countries
have comparative advantages on interest rates, then a swap could benefit both firms.
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For example, one firm may have a lower fixed interest rate, while another has access to a lower
floating interest rate. Êhese firms could swap to take advantage of the lower rates.

*#*
A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset),
such as a physical commodity or a financial instrument, at a predetermined future date and
price. Futures contracts detail the quality and quantity of the underlying asset; they are
standardized to facilitate trading on a futures exchange. Some futures contracts may call for
physical delivery of the asset, while others are settled in cash. Êhe futures markets are
characterized by the ability to use very high leverage relative to stock markets.
Futures can be used either to hedge or to speculate on the price movement of the underlying
asset. For example, a producer of corn could use futures to lock in a certain price and reduce
risk (hedge). On the other hand, anybody could speculate on the price movement of corn by
going long or short using futures.

Êhe primary difference between options and futures is that options give the holder the right to
buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated
to fulfill the terms of his/her contract. In real life, the actual delivery rate of the underlying
goods specified in futures contracts is very low. Êhis is a result of the fact that the hedging or
speculating benefits of the contracts can be had largely without actually holding the contract
until expiry and delivering the good(s).

For example, if you were long in a futures contract, you could go short in the same type of
contract to offset your position. Êhis serves to exit your position, much like selling a stock in the
equity markets would close a trade.