Derivatives are instruments to manage financial risks. Since risk is an inherent part of any investment, financial markets devised derivatives as their own version of managing financial risk. Derivatives are structured as contracts and derive their returns from other financial instruments.

Definition of Derivatives

If the market consisted of only simple investments like stocks and bonds, managing risk would be as easy as changing the portfolio allocation among risky stocks and risk-free bonds. However, since that is not the case, risk can be handled in several other ways. Derivatives are one of the ways to insure your investments against market fluctuations. A derivative is defined as a financial instrument designed to earn a market return based on the returns of another underlying asset. It is aptly named after its mechanism; as its payoff is derived from some other financial instrument.

Derivatives are designed as contracts signifying an agreement between two different parties, where both are expected to do something for each other. It could be as simple as one party paying some money to the other and in return, receiving coverage against future financial losses. There also could be a scenario where no money payment is involved up front. In such cases, both the parties agree to do something for each other at a later date. Derivative contracts also have a limited and defined life. Every derivative commences on a certain date and expires on a later date. Generally, the payoff from a certain derivative contract is calculated and/or is made on the termination date, although this can differ in some cases.

As stated in the definition, the performance of a derivative is dependent on the underlying asset’s performance. Often this underlying asset is simply called as an “underlying”. This asset is traded in a market where both the buyers and the sellers mutually decide its price, and then the seller delivers the underlying to the buyer and is paid in return. Spot or cash price is the price of the underlying if bought immediately.

Derivatives and its Types

Types of Derivatives

Derivative contracts can be differentiated into several types. All the derivative contracts are created and traded in two distinct financial markets, and hence are categorized as following based on the markets:

Exchange Traded Contract

Exchange-traded contracts trade on a derivatives facility that is organized and referred to as an exchange. These contracts have standard features and terms, with no customization allowed and are backed by a clearinghouse.

Over The Counter Contract

Over the counter (OTC) contracts are those transactions that are created by both buyers and sellers anywhere else. Such contracts are unregulated and may carry the default risk for the contract owner.

Derivative Categories

Generally, the derivatives are classified into two broad categories:

  • Forward Commitments
  • Contingent Claims

Forward Commitments

Forward commitments are contracts in which the parties promise to execute the transaction at a specific later date at a price agreed upon in the beginning. These contracts are further classified as follows:

Over the Counter Contracts

Over the counter contracts are of two types:


In this type of contract, one party commits to buy and the other commits to sell an underlying asset at a certain price on a certain future date. The underlying can either be a physical asset or a stock. The loss or gain of a particular party is determined by the price movement of the asset. If the price increases, the buyer incurs a gain as he still gets to buy the asset at the older and lower price. On the other hand, the seller incurs a loss in the same scenario.

For a detailed understanding, you can read our exclusive post on Forward Contract


Swap can be defined as a series of forward derivatives. It is essentially a contract between two parties where they exchange a series of cash flows in the future. One party will consent to pay the floating interest rate on a principal amount while the other party will pay a fixed interest rate on the same amount in return. Currency and equity returns swaps are the most commonly used swaps in the markets.

Exchange Traded Contracts

Exchange traded forward commitments are called futures. A future contract is another version of a forward contract, which is exchange-traded and standardized. Unlike forward contracts, future contracts are actively traded in the secondary market, have the backing of the clearinghouse, follow regulations and involve a daily settlement cycle of gains and losses.

Contingent Claims

Contingent claims are contracts in which the payoff depends on the occurrence of a certain event. Unlike forward commitments where the contract is bound to be settled on or before the termination date, contingent claims are legally obliged to settle the contract only when a specific event occurs. Contingent claims are also categorized into OTC and exchange-traded contracts, depending on the type of contract. The contingent claims are further sub-divided into the following types of derivatives:


Options are the type of contingent claims that are dependent on the price of the stock at a future date. Unlike the forward commitments derivatives where payoffs are calculated keeping the movement of the price in mind, the options have payoffs only if the price of the stock crosses a certain threshold. Options are of two types: Call and Put. A call option gives the option to buy the underlying asset at a specific price. A put option is the option to sell the underlying at a certain price.

Interest Rate Options

Options where the underlying is not a physical asset or a stock, but the interest rates.


Warrants are the options which have a maturity period of more than one year and hence, are called long-dated options. These are mostly OTC derivatives.

Convertible Bonds

Convertible bonds are the type of contingent claims that gives the bondholder an option to participate in the capital gains caused by the upward movement in the stock price of the company, without any obligation to share the losses.

Callable Bonds

Callable bonds provide an option to the issuer to completely pay off the bonds before their maturity.

Asset-Backed Securities

Asset-backed securities are also a type of contingent claim as they contain an optional feature, which is the prepayment option available to the asset owners.

Options on Futures

A type of options that are based on the futures contracts.

Exotic Options

These are the advanced versions of the standard options, having more complex features.

In addition to the categorization of derivatives on the basis of payoffs, they are also sub-divided on the basis of their underlying asset. Since a derivative will always have an underlying asset, it is common to categorize derivatives on the basis of the asset. Equity derivatives, weather derivatives, interest rate derivatives, commodity derivatives, exchange derivatives, etc are the most popular ones that derive their name from the asset they are based on. There are also credit derivatives where the underlying is the credit risk of the investor or the government.

Derivatives take their inspiration from the history of mankind. Agreements and contracts have been used for ages to execute commercial transactions and so is the case with derivatives. Likewise, financial derivatives have also become more important and complex to execute smooth financial transactions. This makes it important to understand the basic characteristics and the type of derivatives available to the players in the financial market.


  • Study Session 17, CFA Level 1 Volume 6 Derivatives and Alternative Investments, 7th Edition

Managed Futures

Managed Futures are a popular variety of alternative investments in the U.S for corporate and businesses. With a low-interest rate regime and low returns on U.S equity markets or …

Actively Managed ETFs

Actively Managed Exchange Traded Funds, or Actively Managed ETFs, are cousins of Exchange Traded Funds. They share similar characteristics and are structured in the same manner as traditional, passively …

Exchange Traded Funds

Exchange Traded Funds are investment vehicles listed on the stock exchange which provide easy access to asset classes by tracking the performance of underlying indices. They are an important …


Hedging Meaning Hedging is a risk management strategy. It deals with reducing the risk of uncertainty related to the adverse price fluctuations in an asset. The aim of this …

Strip and Strap

Strip A strip is delta negative trading strategy. Being delta negative implies that the value of the strip position increases when the price of the underlying security goes down.

Exotic Options

An exotic option is an over the counter (OTC) option which is more complex than commonly traded plain vanilla options in terms of the option behavior with respect to …

Asset Backed Securities

Asset-backed securities (ABS) are debt instruments collateralized by a variety of loans and obligations. These obligations usually include student loans, credit card receivables, auto loans, home equity loans etc. …

Callable Bonds

A normal bond can be issued with embedded options. One such bond is a callable bond. It is like a normal bond but with an embedded call option which …


A warrant is a derivative instrument which gives the warrant-holder a right to buy the underlying stock at a pre-determined strike price. A warrant-holder can exercise it to buy the …

Forward Contract

Forward Contracts A forward contract is the easiest form of derivatives. Here, two parties enter into an agreement either to buy or sell something at a future date agreed …
  • Reverse Factoring
  • Efficiency Ratios
  • Capital Stock
  • Sources of Loan
  • Find us on Facebook

    Related pages

    equipment finance definitiondu pont chartcapitalized cash flow methoddefinition of rationinggaap advantageseps growth formulasharemarketschooladvantages and disadvantages of borrowingecb rbi guidelinesquick ratio formula calculatoradvantages of payback perioddcf method valuationdu pont identity formuladp in banking termsuneven cash flow calculatoraccount receivable ratioaccelerated depreciation methodsdistinguish between pledge and hypothecationdeferred lcpresent value of dividends formulapercentage of sales method calculatorprofit maximization economicsadvantages and disadvantages of bankingwhat is the irr formuladifference between bank overdraft and bank loanacid turnover ratioadvantages of variable costingformula for calculating dividendsweight of debt calculatormeaning of semi variable costhow to calculate wacc of a companypayback period method in capital budgetingwhat is operating lease and finance leasea high receivables turnover ratio indicatesthree major theories of dividend policyleverage analysis ppttraditional theory of capital structuredefine discountingcapital lease entriesdefinition of fixed cost and variable costcalculating roadebenture interestexamples of conglomerate merger companieswhat is meant by contingent liabilitiesretained earnings investopediaclean bill discountingfactoring expensereceivables formuladefinition bookkeepingordinary shares vs preferred sharesdebt equity ratio formula with examplewhat is meant by accounting equationtobin theorycurrent liabilities definition in accountingfixed charge coverage calculatordebenture debtmortgage and hypothecationlc meaning bankingdupont analysis roeinventory turnover definitionpartly convertible debenturesconstant dividend growth model calculatorowners investment advantages and disadvantageshow to calculate weighted average cost of debtdebtors to sales ratiodifference between depreciation and amortisationirr calcualtiondcf stock valuation calculatordays in receivables formulaprerencemeaning of debited in hindihow to calculate degree of financial leveragewhat is the definition of current liabilitieswhat is profit maximisationdefine gdrformula asset turnoverreasons for material price variancenopat financedividend policy determinantsdeferred payment meaning in hindi