In business finance, a derivative is a derived value of an asset. Shares, or currencies can be assets. Based on the derived value, a financial agreement is made between two parties. It is basically a forecasted price of an asset. Underlying is what the forecasted asset is called. In business finance, all derivatives are based on the forecasted value of the underlying.
Exchange-traded and Over-the-counter (OTC) are the two markets in which derivatives are traded. Exchange-traded markets are supported by the stock exchanges. Providing guarantee, stock exchanges minimize transactional risks in exchange-traded markets. Exchange-traded markets are controlled by centralized regulatory mechanism. Also, there are umpteen business finance traders in exchange-traded markets. Stock exchanges also want companies that offer exchange-traded derivatives to become their member through a registration process. In over-the-counter markets, all the above mentioned things are missing. OTC markets are private in nature. On OTC markets, the length of the contract can be mutually decided on.
Swaps, futures, and options are the common types of derivatives. Other types of derivates do exist, since forecasted business finance can be based on any kind of asset or security. Examples of other types of derivatives are foreign exchange derivatives, and equity derivatives. In business finance, futures is a contract between two parties to trade an asset on a future date. Price for the asset will be as of today. The same price will be applicable on the future date of trade. Futures are traded on the futures exchange. The futures exchange is a place where futures contracts are traded.
A swap, like the name suggests, is swapping benefits of a party’s financial instrument for the others’. It is not a replacement business finance mechanism, but rather a win-win business finance mechanism. Here too, the forecasted value of the underlying is taken into account.
Option is another derivative that establishes a non-obligatory contract to buy or sell an asset within a timeframe, and at an agreed price. Options have expiration dates. Within the expiration date trade has to happen. After this date, the option is closed for no other business finance activity.