Derivatives what about it?

Derivatives are contracts that derive their value from the performance of an underlying asset, event, or outcome hence their name.

Since the development of derivatives contracts to help reduce risk, the uses and types of derivatives contracts and the size of the derivatives market have increased significantly. Derivatives are no longer just about reducing risk, but form part of the investment strategies of many fund managers. The size of the global derivatives market is now around $800 trillion. To put this figure in context, the combined value of every exchange-listed company in the United States is around $23 trillion.

Derivatives can be created on any asset, event, or outcome, which is called the underlying. The underlying can be a real asset, such as wheat or gold, or a financial asset, such as the share of a company. The underlying can also be a broad market index, such as the S&P 500 Index or the FTSE 100 Index. The underlying can be an outcome, such as a day with temperatures under or over a specified temperature (also known as heating and cooling days), or an event, such as bankruptcy. Derivatives can be used to manage risks associated with the underlying, but they may also result in increased risk exposure for the other party to the contract. They also allow investors to gain exposure to underlying assets while committing much less capital and incurring lower transaction costs than if they had invested directly in the assets.

There are four main types of derivatives contracts:

• forward contracts .
• futures contracts .
• option contracts .
• swap contracts.

All derivatives contracts specify four key terms:

• the underlying, size and price.
• expiration date.
• settlement.

Underlying Derivatives are constructed based on an underlying, which is specified in the contract. Examples of underlyings include the following:

• Agricultural products (such as wheat, rice, soybeans, cotton, butter, and milk)
• Livestock??
• Currencies Interest rates
• Individual shares and equity indices Bond
• indices Economic factors??
• Natural resources (such as crude oil, natural gas, gold, silver, and timber)
• Weather-related outcomes (such as heating or cooling days)
• Other products (such as electricity or fertilisers)

A derivative's underlying must be clearly defined because quality can vary. Size and Price The contract must also specify size and price. The size is the amount of the underlying to be exchanged. The price is what the underlying will be purchased or sold for under the terms of the contract. The price specified in the contract may be called the exercise price or the strike price.

Note that the price specified in the contract is not the current or spot price for the underlying but a price that is good for future delivery.

Expiration Date All derivatives have a finite life; each contract specifies a date on which the contract ends, called the expiration date.

Some contracts require settlement by physical delivery of the underlying and other contracts allow for or even require cash settlement. If physical delivery to settle is possible, the contract will specify delivery location. Contracts with underlying outcomes, such as heating or cooling days, cannot be settled through physical delivery and must be settled in cash.

Forwards and futures involve obligations in the future on the part of both parties to the contract.

Forwards : a forward contract is an agreement between two parties in which one party agrees to buy from the seller an underlying at a later date for a price established at the start of the contract. The risk that the other party to the contract will not fulfil its contractual obligations is called counterparty risk. To reduce counterparty risk, the parties to a forward contract evaluate the default risk of the other party before entering into a contract. If the risk of default is significant, the parties may not agree to a forward contract.

A Futures contract is similar to a forward contract in that it is an agreement that obligates the seller, at a specified future date, to deliver to the buyer a specified underlying in exchange for the specified futures price. The buyer of the contract is obligated to take delivery of the underlying, and the seller of the contract is obligated to deliver the underlying, although settlement may be with cash. In other words, the buyer of a contract can sell the same contract and the seller of a contract can buy the same contract. The exchange sets the margin amount depending on the underlying's price volatility the greater the underlying's price volatility, the higher the margin. Standardised terms of futures contracts include the underlying; size, price, and expiration date of the contract; and settlement.

Distinctions between Forwards and Futures Forwards and futures differ in how they trade, the flexibility of key terms in the contract, liquidity, counterparty risk, transaction costs, timing of cash flows, and settlement. Forward contracts transact in the over-the-counter market and terms are customised according to the contracting parties' needs. Forward contracts trade in the over-the-counter market and are illiquid. Transaction costs usually are embedded in forward contracts and are not easily visible to the customer. Futures contracts, however, are traded on exchanges through brokerage firms or brokers (agents authorised to trade directly with the exchange), and the transaction costs are visible.

In an option contract, the buyer of the option has the right, but not the obligation, to buy or sell the underlying. If the buyer decides to use??the option, the seller is obligated to satisfy the option buyer's claim. An option contract specifies the underlying, the size, the price to trade the underlying in the future (called the exercise price or strike price), and the expiration date. The option buyer pays this value, or option premium, to the option seller at the time of the initial contract. The farmer may buy a put option to secure the right, but not the obligation, to sell wheat at the exercise price.

Call options protect the buyer by establishing a maximum price the option buyer will have to pay to buy the underlying; the maximum price is the exercise price. A call option is said to be "in the money" if the market price is greater than the exercise price. A call option is "out of the money" if the market price is less than the exercise price. The lower the exercise price for a call option relative to the current spot price, the higher the premium because the likelihood that it will be exercised is greater. The higher the exercise price for a put option relative to the current spot price, the higher the premium because the likelihood that it will be exercised is greater.

Swaps are typically derivatives in which two parties exchange (swap) cash flows or other financial instruments over multiple periods (months or years) for mutual benefit, usually to manage risk.

Swaps of this type involve obligations in the future on the part of both parties to the contract. Similar to forwards and futures, a contract's net initial value to each party should be zero and as one side of the swap contract gains the other side loses by the same amount.

An interest rate swap, the most common type, allows companies to swap their interest rate obligations (usually a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to lower their borrowing costs. Now each company has funds denominated in the other currency (which is the reason for the swap).

The seller is providing protection to the buyer against declines in value of the underlying. The seller does this in exchange for a premium payment from the buyer; the premium compensates the seller for the risk of the contract. The use of swaps has grown because they allow investors to manage many kinds of risks, including interest rate risk, currency risk, and credit default risk.