derivative is a fnancial instrument whose value is based on one or more underlying
assets. In practice, it is a contract between two parties that specifes conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties. The most common types of derivatives are: forwards, futures, options, and swaps. The most common underlying assets include: commodities, stocks, bonds, interest rates and currencies. Hedger n investor who takes steps to reduce the risk of an investment by making an o!setting investment. There are a large number of strategies that a hedger can use. "edgers may reduce risk, but in doing so they also reduce their proft potential. Speculator #ne who attempts to anticipate price changes and, through buying and selling contracts, aims to make profts. speculator does not use the marketin connection with the production, processing, marketing, or handling of a product. $ee: Trader. Arbitrageur #ne who profts from the di!erences in price when the same, or e%tremely similar, security, currency, or commodity is traded on two or moremarkets. The arbitrageur profts by simultaneously purchasing and selling these securities to take advantage of pricing di!erentials (spreads) created by market conditions. $ee: &isk arbitrage, convertible arbitrage, inde% arbitrage, and international arbitrage. Types of Derivative Instruments: 'erivative contracts are of several types. The most common types are forwards, futures, options and swap. Forward Contracts forward contract is an agreement between two parties ( a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. )orward contracts, sometimes called forward commitments , are very common in everyone life. ny type of contractual agreement that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract. Future Contracts futures contract is an agreement between two parties ( a buyer and a seller ( to buy or sell something at a future date. The contact trades on a futures e%change and is sub*ect to a daily settlement procedure. )uture contracts evolved out of forward contracts and possess many of the same characteristics. +nlike forward contracts, futures contracts trade on organi,ed e%changes, called future markets. )uture contacts also di!er from forward contacts in that they are sub*ect to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profts. Options Contracts #ptions are of two types ( calls and puts. -alls give the buyer the right but not the obligation to buy a given .uantity of the underlying asset, at a given price on or before a given future date. /uts give the buyer the right, but not the obligation to sell a given .uantity of the underlying asset at a given price on or before a given date. Swaps $waps are private agreements between two parties to e%change cash 0ows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps. 1. Interest rate swaps: These involve swapping only the interest related cash 0ows between the parties in the same currency. 2. Currency swaps: These entail swapping both principal and interest between the parties, with the cash 0ows in one direction being in a di!erent currency than those in the opposite direction.