Derivative

DEFINITION A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties.
DESCRIPTION
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Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form to extend credit. However, the strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency, can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to mask credit risk from third parties while protecting derivative counterparties contributed to the financial crisis of 2008 in the United States. Financial reforms within the US since the financial crisis have served only to reinforce special protections for derivatives, including greater access to government guarantees, while minimizing disclosure to broader financial markets. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profile.

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