Derivative is a financial instrument whose value is based on or value is derived from one or more underlying assets. The under lying asset may be a share, stock market index, a commodity, an interest rate or a currency. When the price of asset changes value of derivative will also change.it is a contract between two parties where one party agrees to buy or sell any asset at specified dates and rate Derivative is similar to insurance. Insurance protects against specific risk like fire, flood accident, whereas derivatives protects from market risks.
Derivatives are of two categories
1) Exchange traded
2) Over the counter.
Exchange traded derivatives, as the name signifies are traded through organized exchanges around the world. These instruments can be bought and sold through these exchanges, just like the stock market
Over the counter (popularly known as OTC) derivatives are not traded through the exchanges. They are not standardized and have varied features. Some of the popular OTC instruments are forwards, swaps etc.
Derivatives are used by investors for the following purposes:
1) To provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative
2) To speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)
3) To hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
4) To obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives)
5) To create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).