A derivative instrument (or simply derivative) is a financial instrument which derives its value from the value of some other financial instrument or variable. For example, a stock option is a derivative because it derives its value from the value of a stock.
Derivatives are definitely not a modern invention. THey were known and were used from ancient times. Bernstein (1992) attributes the first option transaction to the Greek philosopher Thales from Miletus who was adept at forecasting the harvest of olives in the ensuing season. He predicted an outstanding next autumn and so also the demand for the olive presses. Therefore, he entered into agreements with olive press owners before autumn for the exclusive use of their presses. For this he paid the deposits in advance with an agreement that he will not demand his money if the harvest is not good.
Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.
Options are traded on securities marketplaces among institutional investors, individual investors, and professional traders and trades can be for one contract or for many.
An option contract is defined by the following elements: type (Put or Call), underlying security, unit of trade (number of shares), strike price and expiration date.
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
A swap contract is a contract in which two counterparties agree to make periodic payments that differ in a fundamental way from each other until some future date. The terms of a swap contract, besides the maturity and notional value of the contract, can include the currencies to be exchanged (foreign currency swap), the rate of interest applicable to each counterparty (interest rate swap), and the timetable by which payments are made.
A futures contract is a commitment to buy or sell a fixed amount of a standardized commodity or financial instrument at a specified time in the future at a specified price established on the day the contract is initiated and according to the rules of the regulated exchange where the transaction occurred.
In a forward contract, which is unconditional, two counterparties agree to exchange a specified quantity of an underlying item (real or financial) at an agreed-upon price (the strike price) on a specified date.
Fututres contracts are highly standardized, while each Forward contract is personalized and unique.
Futures are settled at the end on the last trading date of the contract with the settlement price; whereas, the Forwards are settled at the start with a forward price.
The profit or loss on a Futures position is exchanged in cash every day. With the Forwards contract, the profit or loss is realized only at the time of settlement so the credit exposure can keep increasing.
Modern option pricing techniques are often considered among the most mathematically complex of all applied areas of finance. Financial analysts have reached the point where they are able to calculate, with alarming accuracy, the value of a stock option. Most of the models and techniques employeed by today's analysts are rooted in a model developed by Fischer Black and Myron Scholes in 1973.
Mortgage derivatives are investment securities developed by the financial industry to provide different risk and interest-rate profiles from pools of mortgages. Abuses in mortgage derivatives are given part of the blame for the global financial crisis of 2007 and 2008. Another term used for mortgage derivatives is collateralized mortgage obligations, or CMOs.
Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk.
Derivatives are useful for hedging the risks normally associated with commerce and finance. Farmers can use derivatives the hedge the risk that the price of their crops fall before they are harvested and brought to market. Banks can use derivatives to reduce the risk that the short-term interest rates they pay to their depositors will rise against the fixed interest rate they earn on their loans and other assets. Pension funds and insurance companies can use derivatives to hedge against large drops in the value of their portfolios.
Derivatives transactions allow investors to take a large price position in the market while committing only a small amount of capital – thus the use of their capital is leveraged. Derivatives traded in over-the-counter markets have no margin or collateral requirements...