Basket Option - An option with a payoff that is linked to a portfolio or "basket" of assets such as the Fortune 500.
An interest-rate cap is an option that protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate index exceeds a specified strike or cap rate.
A credit derivative is an OTC derivative designed to transfer credit risk from one party to another. By synthetically creating or eliminating credit risk from one party to another. swaption is an OTC option on a swap. . Usually, the underlying swap is a vanilla interest rate swap. Unless stated otherwise, that is how we will use the term in this article. However, the term "swaption" might be used to refer to an option on any type of swap.
There is also a somewhat arbitrary distinction between vanilla and exotic derivatives. The former tend to be simple and more common, the latter more complicated and specialized. There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.
Derivatives are further distinguished from cash instruments in that they are contracts between two or more parties. These contracts are promises to convey ownership of an asset rather than the asset itself. Like other contracts, derivatives represent an agreement between two parties; the terms of the agreement are highly flexible and the contract has a fixed beginning and ending date.
Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, an Asian investor who uses U.S. dollars to buy shares in a
Despite the risks, derivatives are also attractive to investors because they trade for a fraction of the price of the underlying asset, enabling investors to control more of an asset for less money.
Because derivatives are contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Options are the most commonly traded type of derivative. An options contract gives the owner the right to buy or sell an asset at a set price on or before a given date. Other products include futures contracts, forward contracts, warrants and swap contracts. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Key points to remember:
Exchange-traded vs. over-the-counter derivatives
Like their underlying cash instruments, some derivatives are traded on established exchanges (the New York Stock Exchange, the French CAC or the Chicago Board of Trade). These are referred to as exchange-traded derivatives and, generally, they have highly standardized terms and features.
The advantage of exchange-traded derivatives is that regulated exchanges provide clearing and regulatory safeguards to investors.
Many other derivative instruments, including forwards, swaps and exotic derivatives, are traded outside of the formal, established exchanges. These are over-the-counter or OTC-traded derivatives. They can be created by any two counterparties with highly flexible terms and a nearly infinite number of underlying assets or asset combinations. In the OTC derivatives market, large financial institutions serve as derivatives dealers, customizing derivatives for the specific needs of clients.