What Is a Derivative? A derivative is a contract between two parties, the value of which is derived from independent assets or instruments that are said to "underlie" the derivative. Examples include the sale of a commodity or asset on a specified future date, the exchange of currencies on a specified future date and the exchange of interest payments on specified dates. The most common forms of derivatives instruments are: Swap contracts (see Swaps). Option contracts (see Options). . Futures contracts (see Futures). Why Use Derivatives? Derivatives serve two main purposes:- Protecting against nancial risk. For example, if a party is exposed to a rise in oil prices, it could hedge against the risk of that increase by purchasing an option to provide it with the right but not the obligation to purchase oil at a future date at an agreed price (see Options). Speculative investment. For example, derivatives can replicate equity investments at reduced administrative costs and can provide leveraged returns (and losses) on an equity index or a particular equity share in excess of the value of the underlying equities without the actual purchase of the equity security. For more on how and why businesses, institutional investors, lenders and other parties use derivatives, see below and Practice Note, Derivatives: Commerciat Uses. Options Options are contracts between an option buyer and an option seller. The option seller, for a fee (also called a premium), grants the option buyer the right, but not the obligation, to buy or sell an agreed amount of an underlying asset at a xed price (the \"strike price\" or \"exercise price\") on a lture date. Underlying assets that are commonly the subject of options include: ' Commodities such as oil, gas, coal, electricity, wheat or gold. . Equity shares. - Baskets of equity shares. ' The return on an index such as the S&P 500. ' Debt securities such as bonds. Common uses of options include: ' The holder of an equity portfolio buying a put option to sell the portfolio at a xed price at any time during an agreed period to provide a floor under (hedge against) a steep drop in the prices of the equities in the portfolio. - An electricity company buying a call option to purchase coal for use in its business operations at a xed price on a future date to provide a cap on (hedge against) coal price rises. Types of Options The most common types of options are \"put\" and \"call\" options: ' Puts. Put option buyers have the right to sell or deliver an underlying asset to the option seller for an agreed price on an agreed future date. ' Calls. Call option buyers have the right to buy or receive from the option seller an underlying asset at an agreed price on an agreed futtue date. The following are common variations on options, each of which can be either a call or a put option: European-style Option A European-style option can only be exercised at the end of its term or during a specied period. American-style Option An American-style option can be exercised at any point during the term of the option, typically when certain conditions have been met. Bermudanstyle Option A Bermudan-style option can only be exercised on certain dates during the term of the option. Structured Products Options can also form part of an issued security such as a bond. For example, in a convertible bond, issuers combine bonds with call options that allow the bondholder to exchange the bond for shares if the share price reaches the strike price. For more information on equity options and hybrid debt instruments with embedded equity options, see Practice Note, Equity Derivatives Overview (US): Equity Options and Structured Products. Option Settlement Like forwards and futures, options are either cash settled or physically settled (see Settlement of bbrwurds and futures). That is, the parties agree in advance to settle the transaction in one of two ways by the delivery of either: ' Cash; or 0 The actual asset underlying the option. The settlement amount is determined by reference to the strike price specied in the transaction confirmation. The strike price is multiplied by the number of shares, if an equity option, or contracts, if a commodity option, on which the option buyer holds the option. The option holder's prot on an option equals this amount less the fee for entering into the option If the strike price of a call option is below the actual price on the option exercise date, the option will not be exercised and the option buyer's loss is the fee paid for the option. If the strike price of a put option is higher than the actual price on the option exercise date, the option will not be exercised and the option buyer's loss is the fee paid for the option. Option Example The following diagram and accompanying notes describe a simple option. Option Contract Option Premium/Fee Option Buyer Seller Party A Party B Right (but not obligation) to purchase oil at $55 per barrel in one year's timeParty A is concerned that there may be a steep rise in oil prices (we assume a current price of $54 per barrel) and decides to create a hedge by entering into call option contracts with Party B giving it the right to buy oil at an agreed price on a future date from Party B. It purchases 10,000 options expiring in one year's time from Party B and pays a premium for each option. The unit of each option is a single barrel of oil so that Party A can manage its supply needs and decline to exercise the option on barrels it does not need. The options are American-style options and can therefore be exercised at any time, which would result in the physical delivery of the oil. Each option's exercise price is $55 per barrel. If the market price of oil remains under $55 per barrel, Party A will not exercise its options to buy the oil from Party B; it will be cheaper to buy oil \"spot\" on the open market. If the market price of oil rises above $55 per barrel, Party A is protected against the increase and has the option to purchase oil from Party B at $55 per barrel. In the alternative, Party A could enter into cash-settled options (and receive cash) if it does not want to take actual delivery of the oil from Party B, for example, if it already has existing oil suppliers. If a cash-settled option is exercised, Party B pays to Party A the option's market value, that is, the difference between the strike price ($55 per barrel) and the market price of a barrel of oil on the exercise date multiplied by the number of oil option contracts outstanding between the parties