Derivatives are financial instruments whose value is derived from an underlying asset, index, or rate.

Common types of derivatives include futures, options, forwards, and swaps. These instruments are used
for various purposes, such as hedging, speculation, and arbitrage.

A futures contract is an agreement to buy or sell an asset at a predetermined price at a specified time in
the future. Options give the holder the right, but not the obligation, to buy or sell an asset at a specific
price before or on a specified date. Forwards are similar to futures but are customizable and traded over-
the-counter (OTC), rather than on an exchange.

Swaps involve the exchange of cash flows between two parties, typically involving interest rates or
currencies. Derivatives can be used to hedge against risks, such as fluctuations in interest rates, currency
exchange rates, or commodity prices. Speculators use derivatives to profit from anticipated price
movements of the underlying assets.

The valuation of derivatives is complex and depends on factors like the price of the underlying asset, time
to expiration, volatility, and interest rates. Derivatives can be highly leveraged, meaning that small
changes in the underlying asset's price can lead to significant gains or losses.

Accounting for derivatives is governed by standards such as IFRS 9 and ASC 815, which require
derivatives to be recognized at fair value. Changes in the fair value of derivatives are typically recorded in
profit or loss unless they qualify for hedge accounting. Hedge accounting allows for matching the timing
of gains and losses on the hedge with those on the hedged item.

Derivatives carry counterparty risk, the risk that the other party to the contract will default on their
obligations. Regulatory frameworks, like the Dodd-Frank Act in the U.S. and EMIR in the EU, aim to
increase transparency and reduce systemic risk associated with derivatives. Despite their benefits, the
complexity and potential for significant losses have led to criticism and tighter regulation of derivatives
markets.

Financial institutions, corporations, and investors widely use derivatives to manage risk and enhance
returns. Proper risk management and understanding the specific terms and risks associated with each
derivative instrument are crucial for their effective use. The role of derivatives in the 2008 financial crisis
highlighted the importance of transparency, regulation, and prudent risk management in derivatives
trading.