The derivatives can be defined as the financial instruments whose returns are derived from underlying assets. In other words, their performance depends on the movement of underlying assets such as commodities, financial instruments, indices, exchange rates, interest rates, and so on.
Historically, after the collapse of the Bretton Woods Agreement in 1973, where the U.S. suspended the dollar’s convertibility into gold, there was a sharp increase in the volatility of exchange rates and interest rates. Around the same time, the Chicago Mercantile Exchange (CME) launched the first exchange-traded future. Later in 1975, the interest rate futures started trading in Government Nation Mortgage – Certificate of deposits Rollover (GNMA-CDRs) on Chicago Board of Trade (CBOT) and on T-Bill in CME. This can be considered as the beginning of the modern-day derivative market.
In this chapter, we would try and understand the meaning of derivatives and its markets, the basic mechanism through which it operates, its purpose, and how it helps in promoting market efficiency.