derivativesfinancial

Derivatives are financial instruments whose value is derived from an underlying asset, rate, or index. In finance, derivatives are used for hedging risk, for speculative purposes, or to exploit arbitrage opportunities. The main types are forwards, futures, options, and swaps. Forwards are customized contracts traded over the counter to buy or sell an asset at a specified price on a future date. Futures are standardized contracts traded on exchanges with daily settlement (mark-to-market) and collateral, reducing counterparty risk. Options give the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a chosen price before or at expiration. Swaps are agreements to exchange cash flows, such as interest payments or currency values, over time.

Underlying assets include equities, bonds, commodities, currencies, interest rates, and market indices. Pricing and value depend on the characteristics of the derivative, the nature of the underlying, and market factors such as volatility and interest rates. Options are often priced with models like Black-Scholes or binomial trees; futures pricing follows the cost-of-carry framework; swaps are valued by projecting future cash flows and discounting them to present value.

Derivatives enable hedging of price, rate, or currency risk, enabling more predictable cash flows. They also allow speculation on movements in an asset's price and enable complex strategies. However, they carry significant risks, including leverage, liquidity risk, gap risk, and model risk, particularly in the over-the-counter market where counterparty credit risk and collateral requirements matter.

Regulation and market structure vary by jurisdiction, but many markets use centralized exchanges and clearinghouses to mitigate counterparty risk. Derivatives markets have a long history, dating from organized commodity trading to modern, regulated financial markets with sophisticated pricing and risk controls.