Definition: Derivative is a financial instrument that derives its performance from the performance of the underlying asset.
Types of Derivatives:
- Forward Commitments – spot market transaction in future date
- Forward Contract
- Futures Contract
- Swap Contract
- Contingent Claims – on conditional event
- Credit Derivatives
- Asset-backed securities
In forward commitments, you usually do not pay anything upfront. It is just a commitment for future date. Example, as a farmer you want to reduce risk of price fluctuation for your crop that will be ready to sell in market 6 months from now. You get a merchant who is ready to fix the price today for crop to be purchased 6 months later. You do an agreement with that merchant so neither you nor that merchant can back off six months later. After six months if price of crop in market is more than your agreement’s price than you will feel bad because you are selling at low price to the merchant but you may be satisfied because you did not have to worry about price fluctuations. If price of crop in market is lower than your agreement price than you’ll be happy because you took the right decision of fixing the price well in advance. This type of contract is called forward contract. If you do same contract with exchange then it is called futures contract. Swap contract is nothing but a series of forward contracts.
In contingent claims, you usually pay premium upfront. In above example, if you had a contract with merchant such that you are not obligated to sell after six months then merchant will ask to pay some premium for that right up front. After six months, if price in market is lower than contract price you’ll happily exercise contract and sell to merchant. If price is higher than contract plus your total premium than you would not sell to merchant, you will sell crop in market. This is call “Call Option”. Another example of contingent claim: If you have given loan to someone and want to secure your principal, you look for someone (say, person A) whom can make up front small premium payment and get into agreement that if loan taker defaults you’ll get your money from person A. This risk selling is an example of “credit derivative”. One of the credit derivative called CDO (Credit Default Obligation) caused world’s largest insurance company AIG to collapse in 2008 (FED saved it from collapsing by giving 30 billion USD). In another example, consider that you have given loan on five different kinds of things to various individuals. You want to lend more money, so you create a financial document (this process is called securitization) and sell it to other investors. This document says that if you do not get emi from your loan taker you’ll sell loan taker’s assets for which you have given loan and pay to corresponding investors. This way you get more money from investors to actually loan more money. You earn the premium of selling “Asset-backed security”.