A derivative is a financial security with a value that is derives from an underlying asset or group of assets. The derivative itself is a contract between parties based upon the asset. Its price is determined by fluctuations in the underlying asset. Underlying assets include stocks, bonds, commodities, currencies, market indexes, etc.
These can either be traded over-the-counter (OTC) or on an exchange. Derivatives are based upon a wide variety of transactions and have a lot of uses such as speculation, hedging or insuring against risk on an asset.
Benefits of derivatives :
- Reduction in counter-party exposure i.e. Risk of loss from counterparty default would be minimal due to proper margining for market risk.
- Reduced settlement risk, more efficient clearing and settlement system.
- Transparent and reliable valuation of outstanding positions for the market participants.
- Reduced capital requirement to the participants.
- Translation of bilateral gross exposure to multilateral net exposure.
- Improved Operational & Liquidity Efficiency.
- Risk Management
- The ability and chances to make huge and extreme profits is high in derivatives than in case of primary securities or mutual funds.