Overview

Derivative instruments have been a feature of modern financial markets for several decades. They play a vital role in managing the risk of underlying securities such as bonds, equity, equity indexes, currency, short-term interest rate asset or liability positions. In the commodity markets they have, in general, been around for a great deal longer. In modern times the Chicago Board of Trade, for example, was set up in 1848 for the exchange trading of agricultural products such as wheat and corn. The Exchange put in place a mechanism that would play an important role in helping the agricultural community to plan for the future by enabling users of derivatives to lock-in the prices they will receive for their goods before they were even ready for harvesting. In 1865 the Chicago Board formally established its General Rules. This opened the floodgates for spot and forward trading of commodities which ultimately would be delivered to an end user and in 1870 the New York Cotton Exchange was established.

Financial futures contracts, where in many cases no delivery of a physical security is involved (rather settlement is in the form of a cash payment), had to wait another century before taking off. However, once present they succeeded in generating trading volumes in stock indexes, stocks, foreign exchange, bonds and short-term interest rate instruments to unprecedentedly high levels.

Just what are these derivatives, though, and what role or roles do they play? A working definition of a derivative, which will help lay the foundation of...