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A derivative is an instrument whose value is derived from the value of one or more underlying assets, which can be commodities,

precious metals., currency, bonds, stocks, stocks indices, etc. the emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices Types Of Derivatives

The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Here we take brief look at various derivatives contracts that have come to be used. Forwards: A relatively simple derivative is a forward contract. It is a agreement to buy or sell an asset at a certain price. It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today. A forward contract is traded in the over-the-counter market usually between two financial institutions or between a financial institution and one of its clients. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are

standardized exchange traded contracts. Option: Options are traded in both on exchanges and in the over-the-counter market. There are two basic types of option. They are call option and put option. A call option gives the holder (buyer) the right to buy the underlying asset by a certain date for a certain price but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. A put option gives the holder the right to sell the underlying asset by a certain date for a certain price but not the obligation to sell a given underlying asset at a given price on or before a given date. Warrants: Options generally have lives of up to one year, the majority of options traded exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded over the counter. Leaps: The acronym LEAPS means Long Term Equity Anticipation Securities. These are options having a maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually moving average of a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreement between two parties to exchange cash flows in the future according to a pre arranged formula. They can be regarded as portfolios of forward contracts.

A derivative is a financial instrument like an option and or futures contract whose value is derived partly from the value of another security, which is the underlying security. I don't suppose that technical definition shared a tremendous amount of light on the actual meaning of the derivatives. In layman's terms, a derivative is a bet as to whether the value of the underlying security, which might be a stock, bond, or financial index, will increase or decrease by a specified date. Derivatives are typically used to protect asset prices and things like inventories or potential future purchases. In reality, derivatives are a generic term for a wide class of financial products. Some of these products, like futures contracts and options, are well-defined and enjoy a relatively widespread understanding. On the other hand, there are classes of derivatives which exist in a murky and poorly understood environment. These derivatives are usually not traded publicly, but are individual contracts between firms to buy and sell products, or insure against loss (as is the case in credit default swaps) or give a firm the right to buy a product in the future a set price. These non-traded derivatives can be classified as exotic in nature. By exotic, I mean they are each unique to a finite situation that exists between two parties. As you have probably heard on the news, many of these exotic derivatives are poorly understood by both the public and the government. Further, there have been questions raised as to the legality of these derivatives. As an aside, the new financial regulation packages proposed by the government include extensive scrutiny and regulation of exotic derivatives. But getting back to my job, I work only with the "plain Jane" variety of derivatives called futures contracts. Futures contracts are traded on regulated exchanges and there is a high degree of transparency in their daily trading activity. Futures contracts have been around for more than a century, and early derivatives date back to Rice trading in Japan in the 1600s. So the garden-variety derivative, or futures contract, is well understood and heavily traded. You might be surprised at the wide range of commodities, metals, financial indexes, and a host of other unusual futures contracts that can be traded. For example, there are futures contracts on energy products, bond prices, meats and a host of other contracts. Generally these contracts are used to lock-in prices for producers of the products listed above, or the investors of the products listed above. Futures allow a producer to lock-in a price so a firm can produce and price their product with the future in mind. It's important to understand that well-regulated futures provide a valuable service to industry. On the other hand, exotic derivatives have, at times, resulted in extraordinary losses and the most recent derivative problem caused our country to fall into a recession. The purpose of this article is to differentiate between normal, transparent derivatives contracts and the exotic derivatives contracts that have caused so much trouble for our economy.

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