Derivatinstrument

Derivatinstrument is a term used to describe a derivative instrument, a financial contract whose value derives from the performance of an underlying asset, index, rate, or event. Derivatives are used to hedge risk, for speculation, or to implement price relationships. They can be standardized and traded on organized exchanges or customized and traded over the counter (OTC).

The main categories of derivatinstrument include futures, forwards, options, and swaps. Futures are standardized contracts traded on exchanges with daily settlement and margin requirements. Forwards are private, customizable contracts settled at a future date and typically traded OTC. Options give the holder the right, but not the obligation, to buy or sell the underlying at a predetermined strike price. Swaps involve exchanging streams of cash flows, such as interest rate or currency exchanges, between parties.

Crucial to the value of a derivatinstrument are its underlying assets, which can include stocks, bonds, commodities, currencies, interest rates, and indices. Pricing depends on factors such as the current price of the underlying, time to expiry, volatility, interest rates, and dividends (for options). Leverage inherent in many derivatives allows large exposure from a relatively small initial investment, influencing potential gains and losses.

Derivation and use of derivatinstrument span hedging, risk management, price discovery, and speculative strategies. Risks include leverage-related losses, model and valuation risk, liquidity risk, and counterparty risk, particularly in OTC markets. Standardized contracts cleared through central counterparties (CCPs) reduce some counterparty risk. Regulation varies by jurisdiction but often imposes capital, reporting, and clearing requirements to enhance market stability.