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A derivative is a financial instrument whose characteristics and pricing are derived from another underlying instrument. Derivatives are often used to help companies and individuals manage risk (hedge), but can also be used for investment or speculation in the same way as the underlying instrument. They can partially or completely offset the possibility of loss due to changes in market conditions, for example interest rate or currency movements.
The International Swaps and Derivatives Association (ISDA) survey of derivatives usage by the world's 500 largest companies in April 2009 found 94% of these companies use derivative instruments to manage and hedge their business and financial risks. The survey found that foreign exchange derivatives are the most widely used instruments (88% of the sample), followed by interest rate derivatives (83%) and commodity derivatives (for more information about ISDA see their website www.isda.org).
The majority of fixed income derivatives are traded over the counter (OTC) but there are several very liquid derivatives that trade on exchanges that serve as a core pricing point for Australian and overseas fixed income markets. In Australia liquid derivatives include; the bank bill and both three year and ten year bond futures contracts which trade on the Sydney Futures Exchange (SFE).
Given most derivative contracts are traded OTC, counterparty risk (that is the risk that one of the parties may not perform their contractual obligations), must be assessed when entering into a derivatives contract.
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