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 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. Learn how to hedge your stock portfolio using Index Futures Trading. Professional
fund managers hedge their portfolios to limit losses and buy insurance
against expected or unexpected market moving events.
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.
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