Free Financial Markets Operations Management by Keith Dickinson

requires cash/capital for whatever purpose. Investors can purchase these instruments and become either a holder of an issuer's debt and/or a stakeholder in the issuer company.
    We will now continue our look at financial instruments by turning our attention to the derivatives market.
2.6 DERIVATIVE INSTRUMENTS
2.6.1 Introduction
    Whilst issuers are directly involved in the issuance of cash market instruments, they have no such role with derivatives. So what, you might ask, are derivatives? There are many different types of derivatives and we can define the whole class as follows:
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A derivative is a financial contract that derives its value from the performance of another entity, called the “underlying”.
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    If you are comfortable with this definition, here is another from the Office of the Comptroller of the Currency (a department of the US Treasury):
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A derivative is a financial contract whose value is derived from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, and equity prices. Derivative transactions include an assortment of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof. 5
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    What can we learn from the OCC's definition? There are two learning outcomes:
The underlying covers a very broad range of asset types, e.g. interest rates, stock market indices, commodities, share prices, etc.
Derivative transactions fall into four types:
Forwards
Futures
Options
Swaps.
    We can also differentiate derivatives in further ways. Firstly, there are types of derivative product that are constructed by an exchange, traded on the exchange and cleared by a central clearing system. We refer to these as exchange-traded derivatives .
    Secondly, there are other types of derivative product that are constructed by financial entities such as banks and traded away from an exchange between the buyer and the seller. We refer to these as Over-The-Counter (OTC) derivatives .
    Not only are OTC derivatives traded between buyer and seller, but all the post-trade activities also take place between the buyer and the seller, i.e. no central clearing system is involved. This situation is changing, with many of the more straightforward OTC contracts being cleared centrally and the more exotic OTC contracts yet to be decided.
    It is not possible in this book to look at every single derivative product; we will, however, look at one or two examples of ETDs and OTCs. It is sufficient for you to be able to define the four main types of derivatives and understand the prime reasons for using them.
2.6.2 Definitions
We saw that there are four headline types of derivative product and each one can be defined as follows:
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Forwards: A forward contract is a legally binding obligation to buy or sell an agreed amount of an agreed asset at a certain future time for a certain price agreed today.
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This derivative type is OTC.
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Futures: A futures contract is a legally binding obligation to buy or sell a standard amount of a standard asset at a specific time in the future for a certain price that is agreed today.
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    This derivative type is ETD.
    Notice how the definition of a future is similar to that of a forward. The key difference is that the terms of a futures contract are much more standardised with regards to the:
Standard quantity/amount;
Standard (underlying) asset/commodity;
Specific delivery date.
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Options: A call option gives the buyer (the holder ) the right to purchase an asset for a specified price on or before a specified expiration date.
    A put option gives the holder the right to sell an asset for a specified price on or before a specified expiration date.
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    This derivative type can be either ETD or OTC.
    Call options and put options can also be sold; the seller is known as the writer of the contract.
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Swaps: This is a