What are derivatives?Derivatives are the financial contracts or instruments, which derive their value from some other variables. In short, these are the instruments whose value depends on underlying asset. The underlying asset can be equity, index, commodity, bond or currency. Some of the examples of Derivatives are Forwards, Futures, Options and Swaps.Derivatives are financial contracts, which derive their value off a spot price time-series, which is called "the underlying". The underlying asset can be equity, index, commodity or any other asset. Some common examples of derivatives are Forwards, Futures, Options and Swaps.Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. From a market-oriented perspective, derivatives offer the free trading of financial risks.Distinctive Features of Derivatives Market:1. The derivatives market is like any other market.2. It is a highly leveraged market in the sense that loss/profit can be magnified compared to the initial margin. The investor pays only a fraction of the investment amount to take an exposure. The investor can take large positions even when he does not hold the underlying security.3. Market view is as important in the derivatives market as in the cash market. The profit/loss positions are dependent on the market view. Derivatives are double edged swords.4. Derivatives contracts have a definite lifespan or a fixed expiration date.5. The derivatives market is the only market where an investor can go long and short on the same asset at the same time.6. Derivatives carry risks that stocks do not. A stock loses its value in extreme circumstances, whole an option loses its entire value if it is not exercised.Features of financial derivatives

It is a contract: Derivative is defined as the future contract between two parties. It means there must be a contract-binding on the underlying parties and the same to be fulfilled in future. The future period may be short or long depending upon the nature of contract, for example, short term interest rate futures and long term interest rate futures contract.

Derives value from underlying asset: Normally, the derivative instruments have the value which is derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of derivatives depends upon the value of underlying instrument and which changes as per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are closely related.

Specified obligation: In general, the counter parties have specified obligation under the derivative contract. Obviously, the nature of the obligation would be different as per the type of the instrument of a derivative.For example, the obligation of the counter parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract would be different.

Direct or exchange traded: The derivatives contracts can be undertaken directly between the two parties or through the particular exchange like financial futures contracts. The exchange-traded derivatives are quite liquid and have low transaction costs in comparison to tailor-made contracts. Example of exchange traded derivatives are Dow Jons, S&P 500,Nikki 225, NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on.

Related to notional amount: In general, the financial derivatives are carried off-balance sheet. The size of the derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the payoff. For instance, in the option contract, the potential loss and potential payoff, both may be different from the value of underlying shares, because the payoff of derivative products differ from the payoff that their notional amount might suggest.

Delivery of underlying asset not involved: Usually, in derivatives trading, the taking or making of delivery of underlying assets is not involved, rather underlying transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded in respect of underlying assets.May be used as deferred delivery: Derivatives are also known as deferred delivery or deferred payment instrument. It means that it is easier to take short or long position in derivatives in comparison to other assets or securities. Further, it is possible to combine them to match specific, i.e., they are more easily amenable to financial engineering.Secondary market instruments: Derivatives are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the corporate world, however, warrants and convertibles are exception in this respect.Exposure to risk: Although in the market, the standardized, general and exchange-traded derivatives are being increasingly evolved, however, still there are so many privately negotiated customized, over-the-counter (OTC) traded derivatives are in existence. They expose the trading parties to operational risk, counter-party risk and legal risk. Further, there may also be uncertainty about the regulatory status of such derivatives.Off balance sheet item: Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can be used to clear up the balance sheet. For example, a fund manager who is restricted from taking particular currency can buy a structured note whose coupon is tied to the performance of a particular currency pair.What is the importance of derivatives?Derivative is best used as risk management tool by which you can transfer the risk associated with the underlying asset to the party who is willing to take that risk. To simplify the risk term, it has been divided into three parts:

There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks. The fundamental risks involved in derivative business includes: Credit RiskCredit risk arises when any of the parties fail to fulfil the obligation under the agreement. Such an event is called a default. It is also known as 'default risk'.This is the risk of failure of a counterparty to perform its obligation as per the contract. Also known as default or counterparty risk, it differs with different instruments. Market RiskFluctuation in the prices of the underlying asset contributes to market risk. Market risk comprises of four risk factors: Equity risk, Interest rate risk, Currency risk and Commodity risk.Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying asset/instrument. Liquidity RiskLiquidity risk is financial risk that arises due to uncertain cash crunch. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counter-parties to avoid trading with or lending to the institution.The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm faces two types of liquidity risks1. Related to liquidity of separate products2. Related to the funding of activities of the firm including derivatives. Legal RiskDerivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked into carefully.Need and types of financial derivativesThere are several risks inherent in financial transactions and asset liability positions. Derivatives are risk shifting devices: they shift risk from those who have it but may not want it to those who have the appetite and are willing to take it.The three broad types of prices risks are:1. Market risk: Market risk arises when security prices go up due to reasons affecting the sentiments of the whole market. Market risk is also referred to as systematic since it cannot be diversified away because the stock market as a whole may go up or down from time to time.2. Interest rate risk: This risk arises in the case of fixed income securities, such as treasury bills, government securities, and bonds, whose market price could fluctuate heavily if interest rates change. For example, the market price of fixed income securities could fall if the interest rate shot up.3. Exchange rate risk: In the case of imports, exports, foreign loans or investments, foreign currency is involved which gives rise to exchange arte risk. To hedge these risks, equity derivatives, interest rate derivatives, and currency derivatives have emerged.Types of Financial Derivatives:In recent years, derivatives have become increasingly important in the field of finance. Forwards, futures, options swaps, warrants, and convertibles are the major types of financial derivatives. A complex variety of composite derivatives, such as swap options, have emerged by combining some of the major types of financial derivatives:1. Forwards: A forward contract is a contract between two parties obligating each to exchange a particular good or instruments at a set price on a future date. It is an over the counter agreement and has standardized market features.2. Futures: Futures are standardized contracts between the buyers and sellers, which fix the terms of the exchange that will take place between them at some fixed future date. A futures contract is a legally binding agreement. Futures are special types of forward contracts which are exchange traded, that is traded on an organized exchange. The major types of futures are stock index futures, interest rate futures, and currency futures.3. Options: Options are contracts between the option writers ad buyers which obligate the former and entitles (without obligation) the latter to sell/buy stated assets as per the provisions of contracts. The major types of options are stock options, bond options, currency options, stock index options, futures options, and options on swaps. Options are of two types: calls and Puts. A call option gives a buyer/holder a right but not an obligation to buy the underlying on or before specified time at a specified price (usually called strike/exercise price) and quantity. A put option gives a holder of that option a right but not an obligation to sell the underlying on or before specified time at a specified price and quantity.4. Warrants: Warrants are long term options with three to seven years of expiration. In contrast, stock options have a maximum life of nine months. Warrants are issued by companies as a means of raising finance with no initial servicing costs, such as divided or interest. They are like a call option on the stock of the issuing firm. A warrant is a security with a market price of its own that can be converted into a specific share which leads at a predetermined price and date. If warrants are exercised, the issuing firm has to create a new share which leads to a dilution of ownership. Warrants are sweeteners attached to bonds to make these bonds more attractive to the investor. Most of the warrants are detachable and can be traded in their own right or separately. Warrants are also available on stock indices and currencies.5. Swaps: Swaps are generally customized arrangements between counterparties to exchange one set of financial obligations for another as per the terms of agreement. The major types of swaps are currency swaps, and interest rate swaps, bond swaps, coupon swaps, debt equity swaps.6. Swaptions: Swaptions are options on swaps. It is an option that entitles the holder the right to enter into having calls and puts, swaptions have receiver swaption (an option to receive fixed and pay floating) and a payer swaption (an option to pay fixed and receive floating).

Exchange Traded versus OTC Derivatives Markets:There has been a sharp growth of around 40 percent a year in the OTC derivatives markets globally. In the OTC markets transactions take place via telephone, fax, and other elections means of communication as opposed to the trading floor of an exchange. Information technology (IT) has enabled this fast growth in OTC derivatives markets. OTC derivatives contracts are more flexible than exchange traded contracts. However, OTC derivatives markets are characterized by the absence of formal rules for risk (a prerequisite for market stability and integrity), the absence of formal centralized limits or individual positions, leverage or margining and the absence of a regulatory authority.What are the various types of derivatives?Derivatives can be classified into four types: Forwards Futures Options SwapsWho are the operators in the derivatives market? Hedgers - Operators, who want to transfer a risk component of their portfolio. Hedgers are the end users or producers of the particular asset or commodity who hedge against the price rise/fall risk. Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit. Speculators are the risk takers who want to benefit from the risk they take. Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing. Arbitrageurs usually earn profit by trading in two different markets simultaneously or two instruments related to each other.Derivatives are risky instrumentsDerivatives help to improve market efficiencies i.e. by reducing the risk for farmers, oil companies, interest rate risk for banks, etc. But they can turn out to be the cause of the massive destruction in economy. They work as a dependent instrument so if one of the underlying variables goes bankrupt that will lead to fall of whole chain which in turn may wipe out entire financial system.