Derivatives Market

"In Finance,
derivatives is the collective name used for a broad class of financial instruments that derive their value from other financial instruments (known as the underlying), events or conditions. Essentially, a derivative is a contract between two parties where the value of the contract is linked to the price of another financial instrument or by a specified event or condition."

Are the financial markets for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets.

The market can be divided into two, that for exchange traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.

Derivatives are usually broadly categorised by the:

1. Relationship between the underlying and the derivative (e.g. forward, option, swap)
2. Type of underlying (e.g. equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives)
3. Market in which they trade (e.g., exchange traded or over-the-counter)
4. Pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality)

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Another arbitrary distinction is between:

1. Vanilla derivatives (simple and more common) and
2. Exotic derivatives (more complicated and specialized)

There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.

Derivatives are used by investors to:

1. Provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative
2. Speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level)
3. Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
4. Obtain exposure to underlying where it is not possible to trade in the underlying (e.g. weather derivatives)
5. Create optionality where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level)