Derivatives are financial contracts, which derive their value off a spot price time-series, which is called "the underlying". The underlying asset can be equity, index, commodity or any other asset. Some common examples of derivatives are Forwards, Futures, Options and Swaps.
Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. From a market-oriented perspective, derivatives offer the free trading of financial risks
There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks.
For an instance, you can take positions in a "Futures" contract and for a relatively small amount of margin money you can take a larger exposure.
You could also trade in "Options" for a small premium, which gives you the right in case of "Call" option (obligation in case of Writing of any option) to Purchase/ Sell a pre-determined number of shares at a pre-determined price.
Derivatives lets you trade in a large number of stocks and also in Index for a small margin. For example, if you had only Rs 1 lakh instead of Rs 5 lakh to buy a stock, by paying margin of Rs. 1 Lakh you can create position in Derivatives Futures for higher value.
Derivative contracts are of several types. The most common types are Forwards, Futures, Options and Swap.
2. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.