1.1 Introduction

A derivative is a financial instrument that derives its performance (Value) from the performance of an underlying (asset). It’s a legal contract based on the underlying asset.

This underlying asset is also called the underlying variable, or just the underlying. The underlying (asset) may include Equities, Fixed-income securities, Currencies, Commodities, as well as non-assets like interest rates or any other economic variable.

Derivatives pay off on the basis of a source of risk, which is often, but not always, the value of an underlying asset.

Like insurance, derivatives have a definite life span and expire on a specified date.

A derivative contract always defines the rights and obligations of each party.

They involve two parties—the buyer and the seller (sometimes known as the writer)—each of whom agrees to do something for the other, either now or later. The buyer, who purchases the derivative, is referred to as the long or the holder because he/she owns (holds) the derivative and holds a long position. The seller is referred to as the short because he/she holds a short position.

Derivatives play four important roles, namely:

• Risk allocation, transfer and management
• Information discovery such as price as well as implied volatility
• Operational advantages in terms of transaction costs, liquidity, and ease to short
• Market efficiency – prices reflect all available information and no arbitrage gains are possible. Ease of short removes price inefficiencies.