Derivatives are financial instruments whose performance is linked to a specific commodity, security, index, financial instrument or the occurrence or magnitude of an event. Typically, derivatives are used to transfer risk or negotiate the future sale or delivery of an investment. Derivative instruments come in four basic forms: forward contracts, futures contracts, swaps and options.
As an example, consider soybean farmers wishing to contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such transactions would take place through a forward or futures market. This market is the "derivatives market," and the prices on this market would be driven by the spot market price of soybeans which is the "underlying." The terms "contracts" or "products" are often applied to denote the specific traded instrument.
There are two types of derivatives markets, exchange-traded derivatives and over-the-counter (OTC) derivatives. OTC derivatives are privately negotiated deals between two parties which do not go through an exchange or other intermediary. Swaps, forward rate agreements, and exotic options are usually traded in this way. The OTC derivatives market is enormous.
Exchange-traded derivatives include futures and options contracts. The exchange acts as an intermediary for both sides and guarantees the trade. The largest derivatives exchanges by number of transactions are the Korea Exchange, Eurex, and CME Group.
In the second half of 2008, the derivatives market shrank for the first time in its history as the global financial crisis curbed trading, the Bank for International Settlements said in a report. The amount of outstanding contracts linked to bonds, currencies, commodities, stocks and interest rates fell 13.4 percent to $592 trillion, the Basel, Switzerland-based bank said. That was the first decline in 10 years of compiling the data. The amount of credit-default swaps protecting investors against losses on bonds and loans fell 27 percent to cover a notional $41.9 trillion of debt.
Types of Derivatives Products
Derivatives products cover all major asset classes. Derivatives are offered in commodities, currencies, interest rates, equities and equity indexes, precious and industrial metals, energy products, real estate, weather products and others.
Derivatives Trading Around the World
In the United States, futures and options are regulated by the Commodity Futures Trading Commission (CFTC). In the UK, all financial markets, including derivatives, are regulated by the Financial Services Authority (FSA).