Derivative is a contract that derives most of its value from some underlying asset, reference rate, or index. Derivative can be differentiated into several types, including commodity derivatives and financial derivatives.
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commodity derivative is a derivative contract specifying a commodity or commodity index as the underlying.
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financial derivative is a derivative contract specifying a financial instrument, interest rate, foreign exchange rate, or financial index as the underlying. Most common financial derivatives include forward contracts, futures, options, and swaps.
More complex derivatives are used to solve complex risk management problems and to exploit arbitrage opportunities.
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forward contract is a private contract between a buyer and a seller in which the buyer agrees to buy and the seller agrees to sell a specific quantity of a certain security or commodity at the price specified in the contract. The delivery and payment of the underlying instrument occurs at a specified future date instead of immediately. Although the delivery is made in the future, the price is determined on the initial trade date.
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futures contract is a standardized contract in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. A future contract is essentially a forward contract that is traded on an organized financial exchange. Buyers of a futures contract are basically agreeing to buy something that a seller has not yet produced for a set price. Buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market).
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option is contract that gives the counterparties the right (but not the obligation) to buy or sell a specific amount of financial asset at a specific price, at which the contract may be exercised, or acted on. When an option expires, it no longer has value and no longer exists.
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swap is an agreement between two parties, usually an end user and a swaps dealer, to exchange sets of cash flows over a period in the futures. There are five basic kinds of swaps:
interest rate swaps, currency swaps, equity swaps, commodity swaps, and
credit default swap.