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4 Categories of Derivative

4 Categories of DerivativeFinancial derivatives are a financial agreement between two parties. A derivative is a contract with a value that links the expected future payments. Some kinds of financial derivatives include: swaps, futures, and options. Derivatives are often considered a form of alternative investment.

Generally, financial derivatives are separated into a few different categories. Those categories include:

   Relationship between the underlying and the derivation

   Type of underlying (foreign exchange derivatives, interest rate derivatives, or credit derivatives)

   Type of market in which the trade will take place

   Pay off profiles

Derivatives are commonly used to provide leverage, speculate profits, mitigate risk, obtain exposure to underlying, and create option ability.  When a person decides to use a derivative, they must decide whether to use an over the counter derivative or an exchange traded derivative contract.

Common derivative contract types consist of futures, options, and swaps. Futures are a standardized contract written by a clearing house. An option is a contract that gives the owner the right to buy or sell an asset. A swap is a contract that exchanges cash on or before a future date. In some more complex cases, a derivative can be created by combining the elements of futures, options, and swaps.

The negative aspects of a derivative include: a large loss because of the use of leverage and borrowing, risks for the counter party, and a large notional value.