Derivative markets are essentially investment markets that deal with the buying and selling of derivatives. For a lot of novice investors and traders, derivatives may not likely be the first financial instruments that they may want to engage in since it can be quite complex to understand at the onset. Gaining more understanding about derivatives and how the market works can help improve one’s success in terms of investing in it.

What Are Derivatives?

Derivatives are financial instruments that get their value or part of their value from another underlying security or financial instrument. Values of derivatives are also based on several underlying variables. By putting it another way, a derivative is a contract where the gains may depend on the behavior of a certain benchmark or variable. The most common of derivatives include futures, swaps, options and may also include other tradeable securities such as stock and commodities.

Categories For Derivatives

In essence, derivatives are categorized broadly in four ways- the type of underlying asset, the relationship between the underlying asset and the derivative, market they trade in and how their payoff’s are made. Another thing that investors and traders should know is that derivatives are mainly traded as a means to transfer or reduce risk. Derivatives can either be used to speculate on certain securities or as a means to hedge risk or limit losses.

Major Classes Of Underlying Assets For Derivatives

The derivatives market is known to make use of five major underlying assets. The largest class so far in the derivatives market deals with interest rate derivatives. This is a type of derivative where the underlying asset is the right to pay or get a notional amount of money at a specified interest rate. Another underlying asset used in derivatives is currency exchange. A foreign exchange derivative is a type of derivative where the underlying asset may either be a particular currency or its exchange rate.

Still another major class of underlying asset for derivatives in the derivatives market is the credit derivative. This is a type of derivative where the underlying asset is the credit risk of a particular entity. An equity derivative, on the other hand, is a class of derivatives where the underlying asset is derived from one or more equity instruments. Common examples of equity derivatives are options and futures.

Derivative Market Types

There are essentially two known types of derivative markets. One form of the derivative market deals with OTC or over-the-counter derivatives. These are contracts that are directly traded and negotiated between two parties without having to go through an exchange or an intermediary. The usual players in an OTC derivatives market are investment banks and large hedge funds.

Another type of market for derivatives are those that trade derivatives through specialized derivatives exchanges. A derivatives exchange is a market where traders buy and sell standardized contracts defined by the exchange. One advantage of such a market is that the transactions are being regulated up to a certain level which may benefit both parties involved in a derivative contract.