A derivative is a financial instrument or agreement/ contract whose value changes in reaction to the change in a specific underlying asset or financial/ non-financial variable (such as stock market price, bond price, interest rate, commodity price, FX rate, price index, credit rating/ quality, credit index, etc.) and its settlement takes place in the future.
The types of derivatives are options, futures, forward contracts, and swaps. If the instruments/ contracts are traded directly between the parties, without relying on an exchange or an intermediary, the corresponding derivatives are called over-the-counter derivatives (OTC derivatives). On the other hand, exchange-traded derivatives are those traded in an organized and specialized exchange where market participants meet and trade standardized contracts as defined by the exchange.
A derivative is typically characterized by the following aspects:
- its value changes in reaction to changes in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided that, in the case of a non-financial variable, the variable is not specific to a party to the contract (usually known as the ‘underlying’ or ‘underlying asset’);
- it requires no initial net investment or it may require an initial net investment that is less than would be required for other types of contracts that exhibit or would be expected to exhibit a similar patter of reaction to changes in market factors; and
- its settlement, whether physical or cash based, takes place in the future (at a certain future date).
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