Derivatives are assets, which derive their values from an underlying asset. These underlying assets are of various categories like
For example, a dollar forward is a derivative contract, which gives the buyer a right & an obligation to buy dollars at some future date. The prices of the derivatives are driven by the spot prices of these underlying assets
However, the most important use of derivatives is in transferring market risk, called Hedging, which is a protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a very important tool of risk management.
There are various derivative products traded. They are;
Derivatives are supposed to provide some services and these services are used by investors. Some of the uses and applications of financial derivatives can be enumerated as following:
There are many ways in which the derivatives can be categorized based on the markets where they trade; based on the underlying asset and based on the product feature etc. some ways of classification are following:
(1) On the basis of linear and non-linear: On the basis of this classification the financial derivatives can be classified into two big class namely linear and non-linear derivatives:
(a) Linear derivatives: Those derivatives whose Over-the-counter (OTC) traded derivative: These values depend linearly on the underlying value are called linear derivatives. They are following:
(b) Non-linear derivatives: Those derivatives whose value is a non-linear function of the underlying are called non-linear derivatives. They are following:
(iii) Equity linked bonds
(2) On the basis of financial and non-financial: On the basis of this classification the derivatives can be classified into two category namely financial derivatives and non-financial derivatives.
(a) Financial derivatives: Those derivatives which are of financial nature are called financial derivatives. They are following:
The above financial derivatives may be credit derivatives, forex, currency fixed-income, interest, insider trading and exchange traded.
(b) Non-financial derivatives: Those derivatives which are not of financial nature are called non-financial derivatives. They are following:
(3) On the basis of market where they trade: On the basis of this classification, the derivatives can be classified into three categories namely; OTC traded derivatives, exchange-traded derivative and common derivative. Derivative contracts are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. The OTC derivative market is the largest market for derivatives and largely unregulated with respect to disclosure of information between parties. They are following:
(ii) Forward rate agreements
(iii) Exotic options
(iv) Other exotic derivative
(b) Exchange traded derivative: Those derivative instruments that are traded via specialized derivatives exchange of other exchange. A derivatives exchange is a market where individual trade standardized contracts that have been defined by the exchange. Derivative exchange act as an intermediary to all related transactions and takes initial margin from both sides of the trade to act as a guarantee. They may be followings:
(iii) Interest rate
(iv) Index product
(c) Common derivative: These derivatives are common in nature/trading and classification. They are following:
(iv) Binary options