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Derivatives are financial contracts, or financial instruments, whose values

are derived from the value of something else (known as the underlying). The
underlying on which a derivative is based can be
an asset (e.g., commodities, equities (stocks), residential
mortgages, commercial real estate, loans, bonds), an index (e.g., interest
rates, exchange rates, stock market indices, consumer price index (CPI) —
see inflation derivatives), or other items (e.g., weather conditions, or other
derivatives). Credit derivatives are based on loans, bonds or other forms of
credit.

The main types of derivatives are: forwards (which if traded on an exchange


are known as futures); options; and swaps.

Derivatives can be used to mitigate the risk of economic loss arising from
changes in the value of the underlying. This activity is known as hedging.
Alternatively, derivatives can be used by investors to increase the profit
arising if the value of the underlying moves in the direction they expect. This
activity is known as speculation.

Types of derivatives:

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 derivative market is the largest market for derivatives, and is
unregulated. OTC derivatives are largely subject to counterparty risk, as the
validity of a contract depends on the counterparty's solvency and ability to
honor its obligations.

Exchange-traded derivatives (ETD) are those derivatives products that are


traded via specialized derivatives exchanges or other exchanges. A
derivatives exchange acts as an intermediary to all related transactions, and
takes Initial margin from both sides of the trade to act as a guarantee. Like
other derivatives, these publicly traded derivatives provide investors access
to risk/reward and volatility characteristics that, while related to an
underlying commodity, nonetheless are distinctive.

Common derivative contract types

There are three major classes of derivatives:

Futures/Forwards are contracts to buy or sell an asset on or before a future


date at a price specified today. A futures contract differs from a forward
contract in that the futures contract is a standardized contract written by
a clearing house that operates an exchange where the contract can be
bought and sold, while a forward contract is a non-standardized contract
written by the parties themselves.

Options are contracts that give the owner the right, but not the obligation, to
buy (in the case of a call option) or sell (in the case of a put option) an asset.

Swaps are contracts to exchange cash (flows) on or before a specified future


date based on the underlying value of currencies/exchange rates,
bonds/interest rates, commodities, stocks or other assets.

The derivative market performs a number of economic functions. First, prices


in an organized derivatives market reflect the perception of market
participants about the future and lead the prices of underlying to the
perceived future level.

Second, the derivatives market helps to transfer risks from those who have
them but may not like them to those who have appetite for them.

Third, derivatives, due to their inherent nature, are linked to the underlying
cash markets.

Fourth, speculative trades shift to a more controlled environment of


derivatives market.

Fifth, an important incidental benefit that flows from derivatives trading is


that it acts as a catalyst for new entrepreneurial activity.

Sixth, derivatives markets help increase savings and investment in the long
run.
The cash market is a buying strategy in which the buyer makes an
immediate payment that is equal to the current market price for
commodities and other types of securities.

One of the characteristics that sets the cash market apart from a futures
market is this immediate satisfaction and transfer of ownership.

Futures markets involve a longer period for the transaction to be considered


complete. With a cash market, the investor immediately assumes ownership
and is free to do with the commodity or security as he or she wishes.

One of the common designations for a cash market is "spot market." Spot
markets get their name from the fact that business deals are initiated and
completed on the spot, rather than requiring an extended period of time to
resolve. Cash markets tend to be somewhat fast paced, since the turnaround
time on a transaction is so short. Many physical commodities are bought and
sold in this type of market.

The spot market or cash market is a commodities or securities market in


which goods are sold for cash and delivered immediately. Contracts bought
and sold on these markets are immediately effective. Spot markets can
operate wherever the infrastructure exists to conduct the transaction. The
spot market for most securities exists primarily on the Internet.