Financial Instruments: Classification of Derivatives Essay examples

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A derivative is a financial instrument whose value is derived from the value of another asset, which is known as underlying.
• If the price of the underlying assets changes then the value of the derivatives also changes.
• Basically a derivative is not a product. It is a contract which derives its value from the changes in the price of those underlying assets.

Example: The value of a gold futures contract is derived from the value of the underlying asset i.e. gold.

Classification of Derivatives: Derivatives are classified in terms of their payoffs and as exchange traded and over the counters.
• Linear Derivatives: Linear Derivatives have linear payoff. E.g. Futures and forwards.
• Non Linear Derivatives: Non Linear Derivatives have non linear payoffs. E.g. Options.
• Exchange traded: These are standardized instruments and are backed by clearing house. So there is no default risk. E.g. Futures.
• Over the counters: Over the counters are customized contracts and they bare default risk. E.g. Swaps and Forwards.
The history of derivatives is quite colorful and surprisingly a lot longer than most people think. Derivatives were first instruments developed to secure the supply of commodities and facilitate trade as well as to insure farmers against crop failures. The history of derivatives provides…