A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security.
Futures contracts, forward contracts, options, swaps, and warrants are commonly used derivatives.
Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation).
Classes of Derivative Products
Lock products (e.g. swaps, futures, or forwards) bind the respective parties from the outset to the agreed-upon terms over the life of the contract.
Option products (e.g. interest rate swaps), on the other hand, offer the buyer the right, but not the obligation, to become a party to the contract under the initially agreed upon terms.
Current Scenario in Derivative Markets
In 2017, 25 billion derivative contracts were traded.
Trading activity in interest rate futures and options increased in North America and Europe thanks to higher interest rates.
Trading in Asia declined due to a decrease in commodity futures in China.
These contracts were worth around $570 trillion.
Most of the world’s 500 largest companies use derivatives to lower risk.
Derivatives make future cash flows more predictable. They allow companies to forecast their earnings more accurately.
