Comprehensive Report on Derivatives: Types, Applications, and Impact

This report provides a comprehensive analysis of financial derivatives, focusing on four primary types: futures, forwards, options, and swaps. It elucidates how these derivatives function, their applications in risk management and hedging, and their implications for financial systems. The report includes numerical examples to illustrate how each derivative works, along with discussions on their respective merits and demerits. It highlights the roles of hedgers and speculators in the derivatives market and emphasizes the importance of derivatives in price discovery and transaction efficiency. The analysis covers the use of futures contracts for securing future prices, forward contracts for managing foreign exchange risk, options contracts for leveraging asset values, and swap contracts for hedging against price fluctuations. Ultimately, the report underscores the significant impact of derivatives on financial systems through risk management, price discovery, and efficiency of transactions.

Running Head: DERIVATIVE 1
Derivative and Its Four Types
Student’s Name
Institutional Affiliation

Derivative and Its Four Types 2
Abstract
Derivative performance depends on the performance of the underlying asset. Alternatively, there
are four primary types of derivatives; options, swaps, forwards, and futures. Futures contract
provide a definite value certainty on both investors, which minimizes the risks connected with
the volatility price. In spite of this fact, speculators do not prioritize on owning the underlying
product. Instead, they enter the market to make a profit from the falling and rising in prices. The
contract limits the risk exposure, which an investor trades with. Contrary, the forward contracts
are agreements to sell or buy a property at a fixed date and value. Thus, financial institutions
need to adopt approaches that minimize the risks, and reduces the impacts of severe market
movements; the management is possible through hedging. Conversely, option contracts are
derivative of financial securities, which depend on the value of the asset, which allow the
investor to put the odds in their favor. Therefore, the options contract permits a firm the rights,
but not the obligation to sell or buy an underlying asset at a stipulated price before or on a
specific date. Moreover, a swap contract is an agreement between various parties that specifies
the swap terms that may include the legs underlying value, times, and payment frequency.
Hence, the majority of people enter swaps either to hedge against others positions or to predict
the future price of the underlying currency of a free leg. Consequently, Derivatives act as
financial agreements whose returns are connected to the underlying asset performance such as
commodities, bonds, and bonds. Derivatives have a significant impact on the financial systems
through risk management, price discovery, and efficiency of transactions

Derivative and Its Four Types 3
Table of Contents
Introduction…………………………………………………………………5
Financial Firms Utilize Certain Types of Derivatives………………………5
Futures Contracts……………………………………………………………5-7
Forward Contracts………………………………………………………….7-11
Options Contracts………………………………………………………….11-14
Swap Contracts…………………………………………………………….14-15
Numerical Examples on How Each Derivative Works…………………….15
Futures Contracts…………………………………………………………..15-19
Forward Contracts…………………………………………………………19-20
Options Contracts………………………………………………………….20-21
Swap Contracts…………………………………………………………….22-23
Merits and Demerits……………………………………………………….23
Futures Contracts………………………………………………………….23
Forward Contracts…………………………………………………………23
Options Contracts………………………………………………………….23-24
Swap Contracts…………………………………………………………….24
Implications of Derivatives………………………………………………..24-26

Derivative and Its Four Types 4
Conclusion………………………………………………………………26-27
References………………………………………………………………28-31

Derivative and Its Four Types 5
Derivative and Its Four Types
The derivative is an agreement between two parties that derives its value from an
underlying asset. Thus, it is a financial instrument for managing associated risks. Alternatively,
there are four common types of derivatives; options, swaps, forwards, and futures. Moreover, the
underlying corpus created can comprise of one financial security or a combination of several
financial securities. Hence, the underlying asset value is bound to shift as the assets keep
changing continuously. Generally, the underlying asset form depending on the currency, bonds,
stocks, interest, and commodities rates. Therefore, derivative performance depends on the
performance of the underlying asset. Hence, the asset trades in the market where the purchaser
and the seller mutually decide its value, then the seller gives the underlying to the purchaser and
is paid in return. Importantly, cash or spot value is the underlying price if bought immediately.
Analysis
Financial Firms Utilize Certain Types of Derivatives
Most of the retail banking attract deposits and loans. Thus, the difference between
interest rates on loans and deposits creates a profit. As such, the banks play various roles in the
derivatives market. Therefore, banks act as intermediaries in the OTC “over the counter” market,
matching purchaser and sellers, and earning commission fees (Future, n.d). Contrary, financial
institutions participate directly in the derivatives market as purchasers and sellers; they are
derivatives end users.
Futures Contracts

Derivative and Its Four Types 6
Manufactures, importers, and farmers can be termed as hedgers. As such, the hedger sells
or buys in the futures market in securing the commodity’s future price intended to be sold later in
a cash market. Hence, it would assist protect against value risks, and considered an insurance
policy of sorts. Importantly, if someone spends a long time in a futures contract, then the
individual should secure the possible low price. Furthermore, if MNCs short-selling contracts,
then the firms want a high value as possible. Unfortunately, futures contract provide a definite
value certainty on both parties, which minimizes the risks connected with the volatility price.
Using futures contract, hedging can be utilized to lock in an acceptable value margin between
raw material cost, and the retail cost of the final commodity sold.
For instance, when one considers a corn futures contract that represents 5,000 bushels of
corn. This means the corn is trading at five dollars per bushel; the contract price is 25,000
dollars. As such, futures contracts standardize on the particular quality, and amount of the
underlying product (Investopedia, 2018). Therefore, the futures value moves about the spot value
for the product based on the demand and supply.
Market participants may not aim to reduce risks, but instead, benefit from the risky nature
of the future market. These are termed as speculators, which intend to participants intend to
profit from the value changes that hedgers cover themselves against (Investopedia, 2018).
Importantly, while hedgers prioritize on minimizing their risks on their investments, speculators
want to maximize their risk. Thus, maximizing potential profits (Investopedia, n.d). Hence,
speculators do not prioritize on owning the underlying product; rather, they enter the market to
make a profit from the falling and rising in prices.

Derivative and Its Four Types 7
Table 1: This illustrates the differences between speculators and hedgers
Alternatively, in fast-paced markets into which data is continuously fed, hedgers and speculators
mutually benefit from each other. Thus, when the future contact is almost to expire, the better the
information entering the market will be about the specific product. Therefore, the market
participants can expect a more accurate reflection of the demand and supply, and a
corresponding value closer to the expiry date.
Uses of Futures Contracts.
Beers (2018) suggests that futures contracts limit the risk exposure, which an investor
trades with. Therefore, the agreement removes uncertainty regarding the future value of a
commodity. Thus, locking a price for which a firm will sell or buy a particular item, companies
can eliminate the barriers affecting the expected profits and expenses.
Forward Contracts
Juliao (n.d) asserts that the forward contracts focus on MNCs in the foreign exchange
markets. Thus, a firm may engage in business with various partners, who each utilizes its capital,
which means that the company receives payments in several currencies and have to exchange
them back into dollars or any other required currency. The daily fluctuations in the price of these

Derivative and Its Four Types 8
currencies influence the firm’s revenues and costs. Therefore, the company is at risk of losing
funds because of the severe fluctuations. It is essential that MNCs plan their profits and expenses
depending on the market exchange. Conversely, the foreign exchange market comprises of
multiple worldwide transactions utilized by investors for buying foreign currency to selling
domestic currency. Thus, each currency contains its absolute price compared to another, which
determines the exchange rate.
The primary risk of the market is the progressive fluctuations of the exchange rates,
which can bring higher profits or cause severe losses. Importantly, a financial firm needs to
adopt approaches that minimize the risks, and reduces the impacts of severe market movements;
the management is possible through hedging. It may involve using various financial instruments
that increase the protection of investors against fluctuations in the exchange rate of currency
(Juliao, n.d).
Figure 1: Illustrates the change of the US dollar with other currencies from 1968 to 2003

Derivative and Its Four Types 9
Therefore, the forward contracts are agreements to sell or buy a property at a fixed date and
value. Thus, the financial firm can receive capital during a particular time in the contract. As
such, the parties involved are usually enterprises with international banks and operations.
For instance, an American financial firm may need to know the domestic currency, and
how much the company may receive for future transactions in a foreign currency. Hence, the
firm may need to sign a forward contract with a local bank for any payments in Japanese
currency, yen, which the institution will receive in five months. Therefore, the company may
agree on an exchange rate of 116 per dollar, such that if the exchange rate goes up to 125 or
down to 105, the firm will receive the same amount of U.S dollars at 116 yen per dollar.
Importantly, forward contracts enable MNCs to know the precise exchange rate will receive in a
future date; hence, the firm does not need to make predictions.
The currency forwards occasionally follow a simple approach to determine the price or
exchange rate. It may consist of the interest rate and current rate differentials, such that if one
currency A unit plus interest from country A will equal the current value in currency B plus
interest from the same state. For example, for a two-year forward contract, one euro equals 1.15
dollars, and that the annual European interest rate is at one percent and in the U.S, it is 1.5
percent.
Therefore, one euro is equal to 1.557 U.S dollars, which means this will be the exchange rate for
the forward contract.

Derivative and Its Four Types 10
Forward contract participants consist of speculators and hedgers. Consequently, hedgers
do not demand a profit; instead it seeks to stabilize the revenues of their business operations.
Thus, their losses and gains are commonly offset to some percent depending on the
corresponding gain or loss in the market for the underlying property. In contrast, speculators are
occasionally not interested in taking possession of underlying properties (InvestingAnswers,
n.d). Therefore, forward contracts attract more hedgers than speculators.
Uses of Forward Contracts.
Utilizing Forward Contracts for a Rolling Hedge
According to Hood (2018), a rolling hedge refers to an enterprise that will have numerous
distinct forward contracts in place of various expiration dates to cover a particular percent of
their foreign exchange risk over a stipulated period. Therefore, the businesses may book new
agreements weekly, monthly or quarterly for a specific expiration date in line with their
committed exposure.
Table 2: The level and duration of the cover a business may take utilizing rolling hedges

Derivative and Its Four Types 11
Importantly, the technique ensures that the financial institution is continuously assessing and
evaluating the currency market movements. Moreover, it reduces the time-to-time value
deviation-the shorter the time between booking hedges, the less volatile the currency value will
be from one hedge to another.
Utilizing Forward Contracts with Market Orders
Most of the MNCs commonly use rates that are budgeted for setting pricing, formulating,
and monitoring their hedging approach. Nonetheless, achieving these estimated rates is
sometimes reliant on the execution time of the forward contract. Therefore, market volatility
influences the time and date enterprise books a forward contract, which creates a massive
difference in the exchange rate resulting from market fluctuations of standard currency (Hood,
2018).
Options Contracts.
Options contract involve risks and are not appropriate for everyone. Thus, the options
trading is speculative and carry a substantial risk of loss (Downey, 2019). Therefore, option
contracts are derivative of financial securities; the value depends on the amount of the asset. This
means that the option contract allows the investor to put the odds in their favor. These types of
options consist of trade and exchange through a clearinghouse. Importantly, the options contract
permits a firm the rights, but not the obligation to sell or buy an underlying asset at a stipulated
price before or on a specific date. Nevertheless, the call option provides the holder the rights to
buy stock, while a put option grants the holder the right to sell shares.
Puts and Calls Options.

Derivative and Its Four Types 12
The call option acts as a down payment for a future purpose. For instance, a potential
property owner may spot the asset and want to purchase the house in the future, but will only
want to exercise the right once specific establishments around the area are built. Contrary, the
put option acts as an insurance policy. For example, if someone owns a home, then he or she is
likely familiar with the purchasing insurance of the property owner. Thus, an asset owner may
buy the property owner’s policy to cover their home from potential damages. Therefore, the
policy contains a face price, and provides the insurance holder cover in the event the home gets
damaged.
Over-the-Counter Options Differ from Regular Stock Options.
Kennon (2019) assert that over-the-counter options are private party contracts written to
the specifications of each side of the deal. Thus, they do not have any disclosure requirements,
and the firm is limited only in imagination as to what the option terms are. Therefore, the over-
the-counter options appeal is that the firm can transact in private and negotiation terms.
The Counterparty Risk in Over-the-Counter Options
The over-the-counter options lack the protection of an exchange. As such, the MNCs can
conclusively rely on the counterparty promise to live up to their bargaining deal. Therefore, the
options are particularly dangerous when utilized to hedge a firm’s exposure to specific risky
security or property. This is known as a basis risk because the hedges fall apart leaving the
company exposed. Alternatively, when an investment bank partnered with other MNCs to many
OTC options, then it would have entered a “black hole of the bankruptcy court.|”; this is termed
as a “daisy-chain” risk (Kennon, 2019). Therefore, it only takes a couple of over-the-counter
derivative transactions before it becomes impossible to evaluate the total exposure a financial

Derivative and Its Four Types 13
institution may have to a given property. The situation may worsen when the company realizes
that it is in a position where it can be wiped out due to one of its counterparties having
counterparty default on them; this makes them insolvent.
Exchange-Traded Option.
Chen (2018) mentions that it is a standardized contract issued to either seller (utilizing a
put option) or buyer (using a call option) as a set quantity of specific financial commodity, which
is the underlying property, prior or on an expiration date for a strike price. It is essential to note
that these contracts are listed on various exchanges; for instance, the “Chicago Board Options
Exchange” (CBOE). Conversely, the options’ standardization enables the clearing of properties
to guarantee that options contract purchasers can exercise their options.
Utilizing Options Contracts.
Speculation
According to Downey (2019), speculating using a call option attracts some traders
because the options provide leverage. Therefore call option may cost less compared to the full
price of a product. Thus, the leverage options components contribute to their reputation as risky.
Importantly, when an MNCs purchases an option, then it must be certain depending on the
movement of stock, and also the timing and magnitude of the change. Therefore, a company may
need to accurately predict whether the stock will rise or go down, which affects the scope of the
value shift.
Hedging

Derivative and Its Four Types 14
The options that possess hedging may reduce risks at a reasonable cost because it acts as
an insurance policy-options ensure a firm’s investment against certain risks. Therefore, put
options limit risks incurred by a financial institution, which enables it to enjoy the upside cost-
effectively. Contrary, call options can limit losses especially during a “short squeeze.”
Swap Contracts.
The swap derivative instrument allows counterparties to swap or exchange sequences of
cash flow depending on the particular time frame (Investopedia Staff, n.d). Thus, a swap contract
is an agreement between various parties, which specifies the swap terms that may include the
legs underlying value, dates, and payment frequency. Most individuals enter swaps either to
hedge against others positions or to predict the future price of the underlying currency of a free
leg. Additionally, the interest rate swap is an agreement between two parties who willingly
exchange the future payments of the interest rate they make on bonds or loans. These parties
involved in this include financial institutions, hedge funds, and investors (Amaded, 2018).
The speculator may like a hedge fund manager who places a bet on the direction of
interest rate swaps as an ideal instrument. In contrast, the risk of a counterparty is a primary area
of concern for swap investors; any gains over the swap agreement period are termed unrealized
until the following settlement date, and timely payment from the counterparty decides the profit
(Investopedia Staff, n.d). Thus, the failure of a counterparty to meet their obligation may make it
challenging for swap investors to collect payments rightfully.
Uses of Swap Contracts.
The interest rate swaps are a vital tool for numerous investors, risk MNCs and managers, and
corporate treasures because they have multiple potential uses. These are;

Derivative and Its Four Types 15
Portfolio Management
The swaps of interest rate allow the managers’ portfolio to adopt interest rate exposure,
and limits the risks influenced by the volatility of interest rate. Hence, by decreasing or
increasing the exposure of interest rates, managers can either neutralize or ramp-up their
exposure to shifting in the specific view on credit spreads (Pimco, n.d). Also, swaps act as
substitutes for instruments with less liquid fixed income.
Speculation
Swaps need little cash up front, which makes them provide fixed income traders with
speculation on movements in the interest rates, while potentially avoiding the short and long cost
positions in treasuries (Pimco, n.d). For instance, to predict that six-year rate will fall through
cash in a Treasury market, a trader needs to invest some money in buying a “six-year Treasury
note.”
Risk Management
A corporation may decide to grant fixed rate bonds that they occasionally lock in the present
interest rate by taking part in a swap contract. Thus, it gives the corporate time to find potential
investors for the bonds; once the institution sells the bonds, it exits the swap contract.
Numerical Examples on How Each Derivative Works
Futures Contract

Derivative and Its Four Types 16
Table 3: Algebraic Notation for futures values
The algebraic notation is essential for futures contracts. Thus, it is utilized to identify the
underlying security and each of two futures contracts has a present value denoted by 0.
Importantly, the futures value is the price investors agree currently for delayed buying or security
sale at a future date of expiration. The table includes contracts for two periods; Time1, nearby
date and “deferred” date, and Time 2 is the superscripts (Clarke, de Silva, and Thorley, 2013).
Hence, when the two periods arrive, the underlying security value will potentially have shifted to
a new price identified as 1. Therefore, the change in the underlying security value leads to new
estimates for both futures contracts. Consequently, after Time 1 passes, the nearby futures
contracts expire and no longer traded; no amount is listed for Time 2.

Derivative and Its Four Types 17
Graph 1: Illustrates how diversification works in Futures
The graph indicates the unsystematic risks suddenly reduce when a firm diversifies and
adds more stock. Unfortunately, after approximately 20 shares the unsystematic risk is not
diversifiable, which shows that the graph starts to level up after 20 stocks. Therefore, the risks
that maintain after the diversification are systematic risks (Varsity, n.d). These are common to all
stocks especially macroeconomic risks that affect the whole market such as inflation, tightening
of interest rates, and fiscal deficit. Hence, to hedge the position in the spot, one needs to enter
into a counter position in a futures market, which determines if the spot is “long” or “short” in
the futures market.

Derivative and Its Four Types 18
Figure 2: The futures contract of “IDBI bank.”
If a company purchases the futures of “IDBI bank” that has a lot of quantities of 10,000, the
firm gets leverage at a higher rate as the contract value is;
The present value of share x Lot size = price of the contract.
From the image;
Rs 60.25 x 10,000= 602500 as in the period.
Therefore, future contracts do not need to pay the whole price of the contract, which the
company required to pay a margin to participate in the trade (Senft, 2017). Hence, the payable

Derivative and Its Four Types 19
amount is Rs. 106,593 rather than Rs. 602,500 if the firm had purchased through spot value.
Alternatively, if on 10th August the value shifts to Rs. 70, and the company sells, then the profit
can be evaluated as;
The Selling value-buying value= profit
Rs. 70- Rs60.25= Rs.9.75 per share.
In the future, the market is done based on lot size, and the overall profit would be
Rs. 9.75x 10,000 quantity= Rs. 97,500.
Importantly, the amount invested in the futures contract was Rs. 106, 593.
Forward Contracts
Figure 3: Primary dates of FRA
The difference of the interest results from the comparison between FRA rate, and the settlement
rate, which is calculated as;
Interest Differential= (Rate of settlement- Contract rate) x (Contract period/360) x Notional
Amount

Derivative and Its Four Types 20
Thus;
If the rate of settlement rate is greater than the contract rate, then the forward contract buyer
receives the settlement. Contrary, if the contract rate is greater than the rate of settlement, then
the FRA seller receives the settlement amount (Iontafinance.com, 2017). Moreover, is the rate of
settlement is equal to the contract rate, then there is no settlement amount is paid.
Options Contracts
Senft (2017) asserts that a firm expects the value of the stock to fall or rise below the
strike value. Hence, if the company plans the stock price falls below the strike value, the
purchase value is put option, while if the firm expects the stock price to rise above the strike
value, the purchase will be the call option. For example, if a firm expects the IDBI share to shift,
then the purchase is a call option for similar strike values.

Derivative and Its Four Types 21
Figure 4: The Option contract of “IDBI bank.”
If the company chooses a strike value as Rs.57.50 and 30th August as the expiry date, the margin
required by the firm for the trade to occur is Rs.5.25 x 10,000 = Rs.52, 500 on the expiry date.
Hence, the client will buy the expiry option weekly, and the price of the strike value will increase
from “Rs.5.25 to Rs.8.00). The firm can then sell the option before expiry, and make a profit
through;
Selling price- purchase price = profit per share.
Rs.8 – Rs.5.25 = Rs.2.75 per share. Generally, the profit is 2.75 x 10,000 = Rs.27, 500.

Derivative and Its Four Types 22
Swap Contracts
Graph 2: Company XYZ swap rate
A company XYZ may issue ten million dollars in a corporate bond for 15 years with a
variable LIBOR +150 basis points interest rate. Notably, LIBOR is currently three percent, so
the firm pays a 4.5 percent bondholder. After selling the bonds, the company may believe the
LIBOR may increase in the near future. Importantly, the company does not want to be exposed
to a rise in LIBOR, so it entered into a swap contract with an Investor. Additionally, the
company agrees to pay the investor 4.8 percent on a ten million dollar annually for 15 years.
Hence, the investor agrees to pay the firm LIBOR plus 1.5 percent per year for 15 years
(InvestingAnswers, n.d). Therefore, the payment of the floating rate that the company receives
from the investor is always similar to the amounts they need to make on their bondholders. The

Derivative and Its Four Types 23
investor predicts that the variable interest will fall, lowering his interest cost, although the
interest payments from the company will be the same, which allows a gain.
Futures Contracts
Merits
Futures contracts have relatively low margin, and during the exchange, they minimize
counterparty risk (Good Money Guide, n.d).
Demerits
Futures contracts mainly trade on US-based exchanges, and are not flexible for purposes of
accounting. Furthermore, they are primarily dealing with speculative products.
Forwards Contracts
Merits
Forward contracts are developed and written depending on the amount and terms agreed
(Finance Learners, n.d). Alternatively, they offer complete hedges, while also providing price
protection.
Demerits
Most of the forward contracts are challenging to cancel and are often subjected to default risks.
Options Contracts
Merits

Derivative and Its Four Types 24
These allow the firm to employ appropriate leverages that are an advantage to trades. Moreover,
they enable a firm to take a side on the meager capital requirements.
Demerits
They lower the liquidity as most firm’s stock options do not have much volume. Importantly,
each optionable stock has a choice trading at various strike values and expirations, which
influence specific options company trades with; this lowers the amount (Think trade, n.d).
Swap Contracts
Merits
Finance Learners (n.d) mentions that swap is not an upfront premium and it minimizes any
transactions costs. Conversely, they are flexible and maintain informational advantages.
Demerits
Parkih (2010) suggests that a swap deal does not terminate the contract without parties mutually
agreeing in the transactions, which is a dangerous instrument to use. Consequently, swap ’s
secondary markets are not fully established like currency markets, which makes the illiquid and
cannot be traded easily like currencies.
Implications of Derivatives
Policy
Large scale utilization of derivatives has a significant impact on the financial and
economic market environments which monetary policies operate. Thus, they try to evaluate the
degree to which such shifts need to consider while managing and setting monetary policy.

Derivative and Its Four Types 25
Notably, the sole purpose of monetary policy possibly affects the utilization f derivatives on
aggregate inflation and demand (Hentschel and Smith, 1997). Contrary, the stability or instability
of asset prices and the financial market may complicate the monetary policy implementation.
Economic
Derivatives act as financial agreements whose returns are connected to the underlying
asset performance such as commodities, bonds, and bonds. Thus, derivatives have a significant
impact on the financial systems through three primary economic functions; risk management,
price discovery, and efficiency of transactions (Prabha, Savard and Wickramarachi, 2014).
Therefore, derivative securities provide a system which corporations, investors, and nations can
efficiently and effectively hedge themselves against any financial risks.
Political
Derivatives have various implications on political outcomes. Hence, they determine the
relationship between politics and business. This is made possible through the set up of market
trading futures on the assassinations of politics with the aim of eliciting political intelligence via
movement of market prices. Therefore, the derivatives focus on the social excess for new
demands, and needs that shape and define the political environment (Martin, 2014). Conversely,
if the performance of derivatives such as double sessions on the surplus and social value, then
the political debts comprise rearticulating the two moments.
Institutional
Delimatsis and Herger (2011) suggest that CLS bank clears and settle functions for FX
contracts from personal market participants’ failure. Moreover, CLS bank’s efforts focus on

Derivative and Its Four Types 26
expanding CCP clearing into OTC markets such as “credit default swap” (CDS). Therefore, CCP
takes on the risks of counterparties associated with each clearing participants’ contract
performance.
Legislative
Analysis of legal developments in OTC, option, and futures trading influence the
regulations, litigation, and legislation governing derivatives (Thomson Reuters, n.d). Thus, they
help firms anticipate, explain, and interpret the laws and regulations that facilitate business
transactions of commodities, and futures. Banks are encouraged to use derivative regulations
that impede their potential to generate revenue internally to support their operations (Wright,
2010).
Market Competition and Efficiency
Derivatives impact on trading on the volatility of the underlying asset. Hence, the
derivative instruments and the underlying volatility affect the competition and efficiency of the
stock market. Moreover, derivatives reduce associated risks when transacting in business, which
determines the traders bet volumes on the movement of market variables. Thus, derivative
transactions may involve short-selling, default credit swap or speculation on prices that influence
risk generated, market stabilization, and welfare reduction (Heinemann, 2011).
Conclusion
Derivative acts as an agreement between two parties that derives its value from an
underlying asset. In spite of this fact, financial institutions participate directly in the derivatives
market as purchasers and sellers. Thus, most of the MNCs commonly use rates that are budgeted

Derivative and Its Four Types 27
for setting pricing, formulating, and monitoring their hedging approach. Therefore, a financial
firm needs to adopt methods that minimize the risks, and reduces the impacts of severe market
movements; the management is possible through hedging.

Derivative and Its Four Types 28
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