A derivative is a term that refers to a wide variety of financial instruments or “contract whose value is derived from the performance of underlying market factors, such as market securities, interest rates, currency exchange rates and commodity, credit and equity prices. Derivatives generally involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future. The derivatives markets are the financial markets for derivatives. The market can be divided into two groups of derivative contracts. That is Over the Counter (OTC) derivatives and Exchange Traded Derivatives (ETD. The legal nature of these products is very different as well as the way they are traded, through many market participants are active in both. The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivates can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates or indexes. Their performance can be determined both the amount and the timing of the pay-offs.
Two types of derivatives
1. Over The Counter (OTC) Market
OTC markets are traded, huge and privately negotiated directly between two parties, without going through an exchange or other intermediary. It is consist of investment bank who traders who make market in these derivatives, and clients such as hedge funds, commercial banks, government sponsored enterprise. Products that are traded OTC are swaps, forward rate agreements, forward contracts and credit derivatives. OTC presents investment opportunities for informed investors, but also has a high degree of risk and many issuers are small companies with limited operating histories or are economically distressed. Investments are legitimate OTC companies can often lead to the complete loss of the complete loss of investment, and investors should never purchase any security without first evaluating the fundamentals of the company and carefully reviewing the financial statements, management background and other data. Investors who purchase securities based on a “hot trip” or the advice of chat room touts may often be disappointed.
2. Exchange Trade Derivatives (ETD)
ETD is those derivatives products that are traded via specialized derivatives exchanged or other exchanges. It is act as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act a guarantee.
Hedging is a tool to transfer risk by taking the opposite position in the underlying asset and both parties has reduced a future risk. Stock index futures and options are known as derivatives product because they derive their existence from actual market indices, but have no intrinsic characteristics of their own. They lead to greater market volatility is that a huge amount of securities can be controlled by relatively small amounts of margin or option premiums and derivatives popular because can be transacted Off-balance sheet. Hedging allow risk related to the price of the underlying assets to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against...