Derivative is a generic term for a variety of financial instruments. Unlike financial instruments such as stocks and bonds, a derivative is usually a contract rather than an asset. So derivative is a financial security the value of which is derived in part from the value and characteristics of another security or commodity, so called underlying asset. Dealers guess how the price of the underlying security or commodity will change in the future and use derivatives to try to buy them more cheaply.
There are different types of derivatives such as futures, options, swaps, forward contracts and so on. Let's examine them closely.
An options contract is an agreement giving the right, but not the obligation, to buy or sell a security or commodity at a particular price at a particular future time, or in a period of future time. There are two types of options contracts: a call or buyer's option and a put or seller's option. A call option gives the right to buy securities (or a currency, or a commodity) at a certain price during a certain period of time; whereas a put option gives the right to sell an asset at a certain price during a certain period of time.
A futures contract is an agreement giving an obligation to sell a fixed amount of an asset at a particular price on a particular future date. These are standardized deals for fixed quantities that are carried out with the help of brokers between investors who don't know each other. Whereas individual, non-standard, "over-the-counter" deals between two parties are called forward contracts.
A swap is a derivative in which two counterparties agree to exchange one stream of asset against another stream. At present many companies arrange currency swaps and interest rate swaps with other companies or financial institutions. For example, a French company that can borrow francs at a preferential rate, but which also needs yen, can arrange a swap with a Japanese company in the opposite situation. Such currency swaps are designed to achieve interest rate savings, but they are also open to risk, because whether a company saves or loses money will depend on the movement of interest.
It's necessary to say that futures, options and other derivatives exist in order that companies or individuals may attempt to diminish or on the contrary to profit from the effects of future changes in commodity prices, exchange rates, interest rates and so on. In other words, companies and individuals try to hedge their earnings (hedging is just a desire of businesses to buy or sell assets at a guaranteed future price). But also there are people whose main aim is speculating. Speculators, anticipating currency appreciations or depreciations, or interest rate movements, try to gain large sums of money at once.
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