Derivative Securities (or Derivatives) are financial instruments with contractually specified payoffs whose values are uncertain when contracts are initiated and which depend on, or derive from, the values of the underlying assets (stocks, indexes or commodities). There are many types of derivative securities and the most common ones are futures, forwards, options and warrants.

Derivatives are used to hedge risks, to lock in arbitrage profit and to reflect a view on the direction of the market. There are mainly three kinds of participants in the derivative markets, namely the hedgers, the speculators and the arbitrageurs. Hedgers are risk-averse and they use derivatives to avoid uncertainty in price movement. Speculators use derivatives to take advantage of price movement in which they are buying to profit from a price increase and selling to profit from a price drop. Arbitrageurs use derivatives to lock in a riskless profit by simultaneously buying and selling the same, or similar, financial products in different markets.

A futures contract is a legally binding agreement to buy or sell an underlying asset at a pre-determined price (i.e. the futures price) on a specific date (i.e. the settlement date) in the future. It is a standardized contract with specifications in the quality, quantity and delivery date. Futures contracts are traded on organized exchanges and they are usually guaranteed by the clearing house.

Futures contracts are marking-to-market daily at their end-of-date settlement prices. They are often settled by closing out the futures position prior to maturity, rather than requiring physical delivery of the underlying asset or final cash settlement. They can also be terminated by entering into an offsetting position, i.e. an equal and opposite position to the opened position.

Margins are an important aspect of futures markets. Any investor in the futures market is required to keep a margin account, which is adjusted daily to reflect the gains or losses that arises due to marking-to-market. There are two types of margins, namely, initial margin and maintenance margin. Initial margin is the total amount of margin required when a futures position is opened while maintenance margin is the minimum level at which the margin account must be maintained. A margin call will be issued if the margin account falls below the maintenance level because of the adverse price movement and funds must be added to bring the margin account back to the initial margin level.

A forward contract is a private agreement (i.e. not a standardized contract) between two counterparties to buy or sell an underlying asset at a pre-determined price (i.e. the forward price) on a specific date (i.e. the settlement date) in the future. Forward contracts are traded over-the-counter and they are not guaranteed by the clearing house.

Forward contracts are settled at the end of the contracts, rather than marking-to-market daily. They are usually settled in cash or by physical delivery of underlying assets, whereas futures contracts are usually settled by closing out the position.

A option is a contract that gives the holder the right, but not an obligation, to buy or sell a fixed quantity of an underlying asset at a predetermined price (i.e. the exercise price or the strike price) on or before a given date (i.e. the expiry date).