A derivative is a financial security with a value that is reliant upon or derived
from an underlying asset or group assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its price is determined by fluctuation in the underlying assets. The most common underlying assets include stock, bond, commodities, currencies, interest rate, and market indexes. Derivative can either be traded over the counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, where as derivative traded on exchanges are standardized. OTC derivative generally have greater risk for the counterparty than do standardized derivative. The types of derivative consist of: 1. Forward Contract A forward contract is a contract between two parties that dictates which party buys or sells the underlying assets at a predetermined price on a future date. A forward contract could be tailored to any asset and delivery date. It is considered a derivative because its price depends on the price of the underlying assets. For example assume bank wants to buy 1 ton of gold one year from today. On the other hand, bank B currently own 1 ton of gold that it wants to sell one year from today. Both banks could enter into a forward contract and agree on a price and date for the transaction would occur. 2. Future Contract A future contract is a contract between two parties that agree to buy or sell particular underlying assets at a predetermined price in the future. A future contract is a standardized and trades on a future exchange. The price of a future contract is derived from the price of an underlying asset and also has a forward commitment: the purchase or sale of the underlying assets occurs on a future date. 3. Swaps A swap is another derivative that has a forward commitment. A swaps is an agreement between two parties to exchange a series of future cash flows and is tailored to meet the needs of each parties. Swaps depend on underlying financial instrument, such as currencies and commodities, and the exchange of the underlying instrument occurs a future date. 4. Option contract Two types of option contracts exist-call options and put options. Invertors purchase a call option to buy a stock at a specified price and date, and a put option allows investors to sell a stock at specified price and date. The reason why we have derivative instrument such as option and futures, it allow investor to speculate on a securities and indexes. Advantages of option include a smaller investment that transacting in the stock itself, knowing the maximum loss in advance, leverage, and an expansion of the opportunity set available to investor SUMMARY OF STOCK OPTION