The use of derivatives can result in large losses because of the use of leverage/gearing, or borrowing . Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly.

Derivatives focus mostly on two types of risk: Market Risk and Credit Risk

The derivatives market has arrangements in place to mitigate unwanted risks that arise from conducting derivatives transactions. The OTC, Clearing (OTC) and Exchange-Traded have different levels of risk due to their particular characteristics.

In general, we can conclude that the less standardized transactions have a significantly higher risk compared to highly regulated, traded and standardized Exchange-Traded transactions.

Market Risk	Credit Risk	Counterparty Risk	Settlement Risk
Market risk is exposure to the possibility of market movements. Market movements are changes in price or rate of a given underlying (or in value when related to a number of underlyings) that will be delivered in the future. A market risk derivatives contract allows one party to obtain and another party to divest itself of the risk of the price of the underlying moving during an agreed contract period. The universe of those exposed to market risk is wide. - A company that consumes raw material/commodities incurs price risk. - A company that engages in international commerce incurs foreign exchange risk. - A company that borrows money incurs interest rate risk. - A company that invests in other traded firms incurs securities pricing risk. Each of these is a potential risk seller, or possibly even a risk buyer, via market risk derivatives.	Credit risk is exposure to the possibility that a counterparty will default on its obligations when due because of insolvency. Credit risk centers on a specific entity, although market-wide credit deterioration may affect the credit quality of discrete counterparties because of the interlinking of credit exposures. While credit risk is distinct from market risk, in some cases, credit risk can correlate with market risk. Importantly, derivatives do not eliminate underlying risk; they only reposition it. Often, people will use the phrase risk management to explain why parties employ derivatives. This can be misleading because many understand risk management to mean reduction of risk and risk reduction is only one reason to use derivatives.	A party to an OTC derivatives contract faces the risk that the counterparty will fail. This is credit risk and can be divided into two relevant categories: - Counterparty Risk - Settlement Risk Counterparty risk is the risk that the counterparty will become insolvent sometime during the life of the derivatives transaction prior to settlement.	Settlement risk is the risk that, on the settlement date, one party will meet its requirement and the other will not. If the counterparty's failure is due to insolvency, the counterparty may never fulfill its obligation and the compliant party may never have its payment returned. If the counterparty's failure is due to something more mundane, say an operational failure, the compliant party's rights should be enforceable. However, even in the latter context, a delay in settlement is no small affair. A counterparty's failure to settle in a timely fashion can jeopardize the liquidity of the compliant party, which may depend on precisely timed counterparty payments to meet other obligations. To address settlement risk generally, parties can engage in payment netting, also called settlement netting.
Liquidity Risk	Operational Risk	Legal Risk	Systemic Risk
Liquidity risk is the risk that a party will be unable to transact without extraordinary cost or loss due to a lack of immediately available resources or prospects. In the context of OTC derivatives, this risk breaks down into two types: - funding liquidity risk - market liquidity risk. Funding liquidity risk is the risk that a party will not meet its payment obligations due to a temporary cash shortage. If the risk referred to a permanent cash shortage, the risk would more appropriately be called credit risk. In financial institutions, funding liquidity risk arises from cash-flow mismatches, which in turn arise from mismanagement of trades. Market liquidity risk is the risk that a party will not be able to terminate a transaction prior to maturity. Most OTC derivatives contracts are not normally assignable without the consent of the counterparty. This makes them difficult to liquidate, with only limited ways to unwind, i.e., terminate.	Operational risk is the possibility that a derivatives investor internal systems will fail to measure adequately, monitor effectively, or control intelligently the risks to which the investor is exposed. To minimize operational risk, investors of derivatives must constantly calculate their exposure to and appetite for risk. They also must maintain sound plans for contingencies and emergencies, operate an efficient and reliable change of command, and ensure proper internal controls and oversight. These necessities involve human and technological elements. Failures in any of these criteria can lead to unexpectedly large losses.	Generally speaking, parties to OTC derivatives contracts run the risk that certain provisions will not be enforced, either at all or as intended. They might even run the risk that the contracts themselves will be voided. Indeed, even the best-crafted derivatives contract in the most transparent and permissive legal regime runs the risk that the law will change during the life of the derivatives transaction. Legal risk can attach to the contract itself. For example: (i) The contract might be viewed as unenforceable because it is an improper gambling arrangement or an unlicensed provision of insurance; (ii) the contract language might fail to describe precisely the arrangement an injured party intended; Legal risk can also attach to the counterparty. (i) The counterparty might not have the legal capacity to enter into the contract, (ii) the counterparty might be restricted in the purposes for which it enters the derivatives transaction.	Systemic risk is the risk that the whole financial system will collapse because of the initial failure of just one or a few players. According to the critics, each derivatives transaction transfers underlying risk and creates credit risk because a derivatives party may fail to make required payments or deliveries under the derivatives contract. Thus, active derivatives trading generates a web of transactions and credit exposures, as party after party seeks to pass off some of the market or credit risk it has obtained under a derivatives transaction via another derivatives transaction, until a complex network of financial inter dependencies arises among many financial institutions. Under a worst case scenario, one of the derivatives contract parties fails, and then many other parties to many other derivatives contracts also fail, in an unavoidable chain reaction that eventually collapses the financial system.

Futures & Forwards

Swaps

Options

Others

A Forward is an agreement between two parties to deliver an asset in the future at a predetermined price. Futures are the exchange-traded equivalent.

A Future & Forward is the obligation, as opposed to just the right (see Options buyer/holder), to exchange an underlying at a set price on a stipulated future date and, if physically-settled, at a specified location.

Foreign exchange and interest rate Forwards make up the bulk of the Futures & Forwards market.

The obligatory nature of a Futures & Forwards means that a gain to one party will necessarily translate into a symmetrical loss to the other party and vice-versa (if no special features and clauses included).

A Swap is an agreement between two parties to exchange payments/cash flows on regular dates for an agreed period of time. Each payment leg is calculated on a different basis.

In a standard or 'plain vanilla' IRS a party agrees to make future payments to the counterparty determined by reference to a certain fixed or floating rate on a notional amount, and the counterparty agrees to make reciprocal payments at a market floating rate on a notional amount. A Swap is composed of a series of forward contract.

While most Swaps do not, such as currency swaps might require an exchange of notional amount. The main product in the OTC Swap market is the IRS. Swaps trade Over-the-counter (OTC) and have no true counterparts on public exchanges.

An Option is an agreement that gives the buyer/holder, who pays a fee (premium), the right - but not the obligation - to buy (Call) or sell (Put) a specified amount of an underlying asset at a preset price (strike or exercise price) The other side of the transaction is taken by the seller or writer of the option contract.

How do Options differ from Swaps and Futures & Forwards? In a Future & Forward or Swap, the parties lock in a price (e.g., a Future & Forward price or a fixed swap rate) and are subject to symmetric and offsetting payment obligations. In an Option, the buyer purchases protection from changes in a price or rate in one direction while retaining the ability to benefit from movement of the price or rate in the other direction. In other words, the option involves asymmetric cash flow obligations.

Other or Exotic derivatives, refer to derivative instruments which have features making them more complex than commonly traded, "plain vanilla", products. Note that the term has no precise scope: the definition is dependent on time and place.

Interest rate- and currency-swaps were exotic when they first appeared in the 1980s, but are now standard financial tools.

As regards valuation, given their nature, exotic derivatives are usually modelled using specialized simulation- or lattice-based techniques.

Hereafter a short list of SOME Other derivatives:
- Exotic Options ( e.g., Barrier Options, Binary Options, Lookback Options, Chooser Options,...)
- CDS, CLN, ABS, TRS,...
- Swaptions
- Weather derivatives

Hedging	Speculation	Arbitrage
Hedging is protecting. More specifically, it is the process by which an exposed entity enters into a transaction that will generate profit in the exact circumstances that would generate a loss under the exposure. Hedging an exposure reduces risk, but also costs a reduction in contingent reward from the exposure. Hedging can offset all or part of a certain risk, either closing out or only moderating the risk-causing position. Hedging with derivatives may not always be appropriate for all parties at all times. For example, some multinational corporations with foreign currency revenues prefer to create natural hedges by generating foreign currency profits with same-currency costs, or self-insure their currency risks, rather than hedge with derivatives.	Speculators buy or sell derivatives without true exposure to or core interest in the underlying risk. While speculators increase their holistic exposure, hedgers reduce their holistic exposure. Yet, where hedging stops and speculation begins is not always clear.	Arbitrageurs are market players who take advantage of either price mismatches or artificially restricted opportunities or who stake positions before markets react to certain events. At its most basic, arbitrage is buying an item in one market and concomitantly selling it in another market, thereby exploiting a difference in prices due to market inefficiencies. Because arbitrage depends on market imperfections, arbitra-geurs depend on speed and opacity " they seek to profit before they are copied, spreads narrow, or access is prevented ". Additionally, leverage and large volumes can be key to arbitrage because arbitrageurs seek to profit from minor market movements.

Hedging	Speculation	Arbitrage
Hedging is protecting. More specifically, it is the process by which an exposed entity enters into a transaction that will generate profit in the exact circumstances that would generate a loss under the exposure. Hedging an exposure reduces risk, but also costs a reduction in contingent reward from the exposure. Hedging can offset all or part of a certain risk, either closing out or only moderating the risk-causing position. Hedging with derivatives may not always be appropriate for all parties at all times. For example, some multinational corporations with foreign currency revenues prefer to create natural hedges by generating foreign currency profits with same-currency costs, or self-insure their currency risks, rather than hedge with derivatives.	Speculators buy or sell derivatives without true exposure to or core interest in the underlying risk. While speculators increase their holistic exposure, hedgers reduce their holistic exposure. Yet, where hedging stops and speculation begins is not always clear.	Arbitrageurs are market players who take advantage of either price mismatches or artificially restricted opportunities or who stake positions before markets react to certain events. At its most basic, arbitrage is buying an item in one market and concomitantly selling it in another market, thereby exploiting a difference in prices due to market inefficiencies. Because arbitrage depends on market imperfections, arbitra-geurs depend on speed and opacity " they seek to profit before they are copied, spreads narrow, or access is prevented ". Additionally, leverage and large volumes can be key to arbitrage because arbitrageurs seek to profit from minor market movements.

Derivatives come in flavors from plain vanilla to mint chocolate-chip. In practice, financial derivatives cover a diverse spectrum of underlyings, including equity or stock indices, exchange rates, interest rates or bonds, credit characteristics, commodities or more exotic underlyings (i.e., weather characteristics).

Human creativity, however, can make derivatives complex and therefore at the mint chocolate-chip end of the spectrum the sky is the limit. Practically nothing limits the financial instruments, reference rates, or indices that can serve as the underlying for a financial derivatives contract.

Some derivatives, moreover, can be based on more than one underlying. For example, the value of a financial derivative may depend on the difference between a domestic interest rate and a foreign interest rate (i.e., two separate reference rates).

See the following additional information:

The foreign exchange market is the most liquid financial market in the world. As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks.

According to the Bank for International Settlements (BIS), as of April 2010, average daily turnover in global foreign exchange markets is estimated at $ 3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007.

The $3.98 trillion break-down is as follows:

$1.490 trillion in spot transactions --- non-derivative
$475 billion in outright forwards --- derivative
$1.765 trillion in foreign exchange swaps --- derivative
$43 billion currency swaps --- derivative
$207 billion in options and other products --- derivative

Exchange-Traded	Cleared (OTC)	Over-the-counter (OTC)
Trades executed on organized exchanges Offered products designed to be fungible (liquid) Trades limited to inflexible and standardized contracts terms and conditons set by exchange All trades are booked with exchange's clearinghouse, which is counterparty to all trades Mandatory margin in cash or eligible securities must be provided by each market participant to collateralize contingent obligations on open contracts Margin provision can be divided into two stages: - Initial margin - Variation margin Daily settlement (mark to market) and margin calls Here are three links to the most popular exchanges: - www.cmegroup.com - www.theice.com - www.eurexchange.com	Trades negotiated over-the-counter Trades limited to highly standardized contracts All trades are booked with clearinghouse, which is counterparty to all trades Mandatory margin in cash or eligible securities must be provided by each market participant to collateralize contingent obligations on open contracts. Margin provision can be divided into two stages: - Initial margin - Variation margin Daily settlement (mark to market) and margin calls	Trades negotiated over-the-counter bilaterally in non-centralized markets Customized contracts: An important consequence of the made-to-order nature of OTC derivatives contracts is that parties can trade the risk of relatively unique underlyings. Equally important, OTC derivatives buyers and sellers can structure transactions with unique terms and conditions An OTC derivatives contract party must pay relatively close attention to the possibility that the counterparty will fail to make good on obligations. OTC derivatives parties have devised a number of techniques, such as netting and credit support, to minimize bilaterally the risk of counterparty default Margin (collateral) often exchanged but subject to negotiation between counterparties Follow this link to find out more about ISDA: - www2.isda.org