Derivative Instruments

Derivatives have become a major component of market risk for more than 20 years because banks continue to create innovative products to its customers. Previous products called "cash instruments" because it is the basic instrument for derivative products.
The main characteristic of the principal amount of derivatives transactions is not traded, thus reducing the credit risk and settlement risk. Derivatives are often called 'contracts for difference' because that is exchanged is a change from the cash price of the traded instrument. Because credit risk is reduced, then the banks can trade derivatives with a lot of cash compared to the instrument, so that makes markets more liquid and the resulting growth in trading volume and the amount of risk taken by banks.

Some derivatives are traded on futures exchanges and options traded on the over-the-counter (OTC) market. OTC market is a market where banks trade directly with each other and not through the stock.

One of the important derivatives are future contracts. These contracts are traded through exchanges which act as a clearinghouse for all parties. Therefore, banks do not have to deal with credit risk from many parties, but only with the stock alone. Future contracts are deals to be done on the basic instrument in the future. There are future contracts for most of the cash instruments ranging from bonds to commodities.

In general, future contract has the characteristics:
- Exchange traded → traded through the stock
- Value of fixed per-contract
- Date of delivery has been established
- Terms of delivery must be appropriate
- Daily margin calls

Future contract risk as instruments are essentially features and interest rate risk because the transaction date in the future.