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In general, a derivative is a conditional instrument used by market participants to trade or manage an asset. There are essentially two categories of financial instruments that are grouped under the term derivatives: options/futures and swaps. Options or futures are different kinds of contracts where one party agrees to pay a fee to another for the right to buy or sell something to the other. For example, a person worried that the price of his Microsoft stock may go down soon just before he plans to sell it may pay a fee to another person who agrees to buy the stock from him at today's price. The person in this example is using an option or future to manage the risk that his stock may go down, while the person he pays a fee to might be using the option as a way to speculate that Microsoft's stock will actually increase, and if so would earn more money then if he were to simply buy Microsoft's stock. Later, contracts known as swaps appeared, where one party agrees to swap something with another depending on certain circumstances. For example, one person desiring a fixed rate loan for his business-1, finding that all banks only offer him a variable rate, enters into an agreement with business-2 to have business-2 pay business-1 when rates go up and business-1 must pay business-2 when rates go down, effectively creating a fixed rate for business-1 and possibly saving business-2 money or helping it to convert some of its fixed rate debt into variable rate. Since both of these types of contracts were between two parties, and could be used for risk management or speculation, these contracts became commonly known as "derivatives".

Derivatives can be based on different types of assets such as commodities ,equities or bonds interest rates , exchange rates , or indices (such as a stock market index , consumer price index (CPI) or even an index of weather conditions). Their performance can determine both the amount and the timing of the payoffs. The main use of derivatives is to either remove risk or take on risk depending if one were a hedger or a speculator. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. The main types of derivatives are futures , forwards , Option> and swaps . In today's uncertain world, derivatives are increasingly being used to protect assets from drastic fluctuations and at the same time they are being re-engineered to cover all kinds of risk and with this the growth of the derivatives market continues.

Usages

One use of derivatives is as a tool to transfer risk .For example, farmers can sell futures contracts on a crop to a speculator before the harvest. The farmer offloads (or hedges ) the risk that the price will rise or fall, and the speculator accepts the risk with the possibility of a large reward. The farmer knows for certain the revenue he will get for the crop that he will grow; the speculator will make a profit if the price rises, but also risks making a loss if the price falls.

It is not uncommon for farmers to walk away smiling when they have lost out in the derivatives market as the result of a hedge. In this case, they have profited from the real market from the sale of their crops. Contrary to popular belief, financial markets are not always a zero-sum game. This is an example of a situation where both parties in a financial markets transaction benefit.

Another example is the company General Electric . This company uses derivatives to "match funding" (GE webcast on derivatives to mitigate interest rate and currency risk, and to lock in material costs. The program is strictly for forecasted and highly anticipated needs, and not a means to generate non-operating revenues. 90% of all derivatives revenue produced by derivatives sellers is for this kind of cost, cash, accounts receivable and accounts payable planning. On 2005-06 the company restated earnings with as much as $0.05 quarterly EPS (over 10%) in Q3 2003

Of course, speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities.

Derivatives such as options, futures, or swaps, generally offer the greatest possible reward for betting on whether the price of an underlying asset will go up or down. For example, a person may believe that a drug company may find a cure for cancer in the next year. If the person bought the stock, for $10.00 and it went to 20.00 after the cure was announced, the person would have made a 100% return. If he borrowed money to buy the stock (in US law the general maximum he could borrow would be 5.00 or half of the purchase price), he could have bought the stock for 5 dollars and made a 300% return. However, if he paid a 1 dollar option premium to buy the stock at 11 dollars, when it shot up to 20 dollars he could have recieved the difference (9 dollars) and thus make a 900% return.

Other uses of derivatives are to gain an economic exposure to an underlying security in situations where direct ownership of the underlying is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position.

In addition to directional plays (i.e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the volatility of the underlying security. This technique is commonly used when speculating with traded options.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson , a trader at Barings Bank , made poor and unauthorized investments in index futures. Through a combination of poor judgment on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake , Leeson incurred a 1.3 billion dollar loss that bankrupted the centuries old financial institution. 

Types of derivatives

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps , forward rate agreements , and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements , the total outstanding notional amount is USD 298 trillion (as of 2005)

Exchange-traded derivatives are those derivatives products that are traded via Derivatives exchanges . A derivatives exchange acts as an intermediary to all transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largestderivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), Chicago Mercantile Exchange and the Chicago Board of Trade According to BIS, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005. 

There are three major classes of derivatives:

Futures /Forwards , which are contracts to buy or sell an asset at a specified future date.

Options , which are contracts that give the buyer the right (but not the obligation) to buy or sell an asset at a specified future date.

Swaps , where the two parties agree to exchange cash flows. 

An individual or a corporation should carefully weigh the risks of using these instruments since losses can be greater than the money put into these instruments. It should be understood that derivatives themselves are not to be considered investments since they are not an asset class. They simply derive their values from assets such as bonds, equities, currencies etc. and are used to either hedge those assets or improve the returns on those assets. 

The payments between the parties may be determined by:

the price of some other, independently traded asset in the future (e.g., a common stock );

the level of an independently determined index (e.g., a stock market index or heating-degree-days);

the occurrence of some well-specified event (e.g., a company defaulting );

an interest rate ;

an exchange rate ;

or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly. 

Market and arbitrage-free prices Two common measures of value are:

Market price , i.e. the price at which traders are willing to buy or sell the contract

Arbitrage -free or the theoretical price, meaning that no riskless profits can be made by trading in these contracts; see rational pricing 

Determining the market priceFor exchange traded derivatives, market price is usually transparent (often published in real-time by the exchange, based on all the current bids and offers placed on that particular contract at any one time).Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices. 

The arbitrage-free price for a derivatives contract is often complex, partly because of this there are often many different variables to consider. A key equation for the theoretical valuation of options is the Black-Scholes formula , which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model 

The two types of derivatives have two distinct controversies associated with them. Options or futures can allow a person to pay only a premium to bet on the direction in an asset's price, and while this can often lead to 900% returns if the person is right, it would lead to a 100% loss (the premium paid) if the person is wrong. In fact, options or futures where a person agrees to sell something to another in exchange for a fee could lead to unlimited losses if the person doesn't own that thing and the price of the thing goes higher and higher. .

On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1.6 billion through derivatives trading.

The potential for these kinds of large losses have given derivatives a certain notoriety.

The other controversial risk of derivatives (primarily swaps) is known as counter party risk. For example, a person wanted a fixed interest rate loan for his business, finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have gone up a lot, it is possible that the first business may go bankrupt too because it can't afford to pay the higher variable rate. This chain reaction effect worries certain economists, who feel that since many derivative contracts are so new, the effect could lead to a large disaster. Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses. Or banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However private agreements between two companies may have an unknown amount of due dilligance performed on each other, and this unknown has caused a lot of anxiety for many economists.

Because derivatives offer the possibility of large rewards, many individuals have a strong desire to invest in derivatives. Most financial planners caution against this, pointing out that an investor in derivatives often assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small investor One should keep in mind that one purpose of derivatives is as a form of insurance , to move risk from someone who cannot afford a major loss to someone who could absorb the loss, or is able to hedge against the risk by buying some other derivative.

Economists generally believe that derivatives have a positive impact on the economic system by allowing the buying and selling of risk. Since someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system. However, many economists are worried that derivatives may cause an economic crisis at some point in the future.

(Source/Reference: Wikipedia.org)