The term `Derivative' means that it has no independent value and its value id entirely `derived' from the value of the underlying asset. They are financial contracts, which derive their value off a spot price time-series, which is called "the underlying". The underlying asset can be commodities, securities, bullion, currency, livestock or anything else.
Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. From a market-oriented perspective, derivatives offer the free trading of financial risks. Using derivatives breaks risk into pieces that can be managed independently.
There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks. The fundamental risks involved in derivative business include:
- Credit Risk: Also known as default or counterparty risk, this is the risk of failure of a counter party to perform its obligation as per the contract. It differs with different instruments.
- Market Risk: It is a risk of financial loss as a result of adverse movements of prices of the underlying asset/instrument.
- Legal Risk: Derivatives cut across judicial boundaries; therefore the legal aspects associated with the deal should be looked into carefully.
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