Derivative contracts are instruments that derive their values from the values of the underlying instruments upon which they are based on, like equities (e.g. stocks & shares of companies, stock indices etc.) and commodities (e.g. oil, gold, wheat etc). They are contractual agreements between buyers and sellers that specify the exchange of certain privileges and liabilities.

Derivative contracts include forward contracts, futures contracts, options, and swaps. They are used for arbitrage, speculation and hedging. Professional fund managers use these instruments to hedge their portfolios to limit losses and buy insurance against expected or unexpected market moving events. Arbitrageurs try to profit by exploiting pricing inefficiencies in the market while speculators hope to profit by betting on directional moves of a particular trading instrument.

Characteristics of Derivative Contracts

Some of the characteristics of derivative contracts are as follows:

Zero Net Supply

Sellers create derivative contracts when they first sell them. Derivative contracts therefore are in zero net supply. The sum of all long positions minus the sum of all short positions is always zero.

Element of Futurity

All derivative contracts have an element of futurity: Their values depend on future events. For example, the prices of futures, options, and forwards all depend on futures prices of their underlying instruments.

Expiration of Derivative Contracts

Almost all derivative contracts have an expiration date. For example, the S&P 500 Stock Index Futures traded on the Chicago Mercantile Exchange (CME) expire quarterly in March, June, September and December. On that date, traders make final settlement and the contract expires. Contracts that do not expire are infinitely lived. Exchanges and investment banks have proposed many infinitely lived derivative contracts, but none have been notably successful.

Settlement of Derivative Contracts

Derivative Contracts may be physically settled or cash settled. A physical settled contract requires that the seller deliver the underlying instrument to the buyer when obligated to do so. At that time, the buyer pays cash for the instrument at the agreed price. A cash settled contract requires that the seller deliver the cash value of the underlying instrument to the buyer when obligated to do so. At the same time, the buyer pays the agreed-upon purchase price. In practice, the traders transfer only the difference between the value and the price. If the contract is a futures contract, the difference might be negative. In that case the seller pays the buyer the difference. If the contract is an options contract, the difference will never be negative because contract holders will not exercise their options when doing so would require that they make additional payments.