A derivative is a traded security in the form of a contract between two parties based on an underlying asset or multiple assets. These financial contracts are most commonly used to hedge financial risk. Derivatives can also be used for speculative purposes such as predicting the future value of an asset and potentially profiting or losing from the ultimate outcome of the underlying asset.
Derivatives contracts first began with commodities trading. For example, people often used agricultural goods to make trades, swapping rice for beans or agreeing to repay someone for a good at a future date. With the creation of money and more advanced forms of exchange, the concept of derivative contracts was then applied to more abstract notions such as credit and interest rates.
Derivatives are categorized as either over the counter (OTC) or exchange traded (ETD) such as a futures contract via a commodities exchange.
An OTC derivative involves two parties that engage in a contract without going through a public exchange. OTC derivatives have been highly unregulated and have tended to be the most common type of derivative contract, especially for large banks and hedge funds. Because the transaction is private, OTC transactions have been unregulated as was seen during the financial crisis of 2008-09.
While OTC derivatives allow individuals and firms to profit greatly, they can and have proven to be detrimental when safeguards for the underlying assets have been disregarded or were the result of fraudulent activity. Since the collapse of investment bank Lehman Brothers in 2008, U.S. regulators have been working to reform OTC derivatives namely by means of increasing regulation and transparency. In particular, the reforms will effectively end bilateral OTC transactions and will require OTC instruments to be executed and cleared via established and new venues. Many of the mandates for OTC reforms are included in the Dodd-Frank Act, passed by the US Congress.
Many of the OTC reforms will be patterned after the practices of exchange trade derivatives (ETD) transacted through the use of standardized contracts. Some examples of major exchanges that trade derivatives include the CME Group, Eurex, the London Metal Exchange, InterContinental Exchange (ICE) and the Korean Exchange. The most common form of an ETD is an option or future.
In general, there are five major derivative contracts: options, futures, forwards, swaps and exotics.
An option gives the owner of the asset the right to buy (call option) or sell (put option) the asset at a “strike” price.
As previously alluded to, a futures contract is an agreement to buy or sell an asset at a future date, making standardized payments, generally by month. Futures contracts tend to be extremely diverse, as they can include a wide range of commodities, from oranges to soybeans to metals, power and energy. The first futures contract, for instance, was the Dojima Rice Exchange, dating back to 1967.
A forward is similar to a future in that it is an agreement to buy or sell an asset, yet the date is unknown and payments are generally not standardized.
Swaps generally take place when a security is sold in “swapped” with another security or financial instrument. Some common examples of swaps include interest rate swaps or credit default swaps.
Exotics are among the most complex of derivatives, and generally take the form of a highly non-standardized contract.
According to the Bank of International Settlements (BIS), as of June 2011, the estimated value of OTC markets is $708 trillion while the ETD market is currently estimated to be at around $344 trillion.