A derivative is a contract between two or more parties, the value of which is based on an underlying financial asset, index, or security.Examples of underlying assets, indices and securities include commodities, interest rates, stocks, foreign currency. Bank for International Settlements (2016), ‘Glossary’, October. Derivatives are used as financial instruments to help companies hedge various risks—for example, fluctuations in interest rates and foreign currency exchange—that their businesses are exposed to. Derivatives can be traded on securities exchanges that offer standardised contracts, or can be traded OTC, involving privately negotiated contracts between parties.
As OTC derivatives contracts are privately negotiated and are not required to be standardised,Thomson Reuters Practical Law (N.D.), ‘Over-the-counter (OTC) Derivative’. the International Swaps and Derivatives Association (ISDA) developed the ISDA Master Agreement—an umbrella agreement setting out standard contract terms between parties trading OTC derivatives. The ISDA Master Agreement provides parties with certain legal and credit protections, and is commonly used for OTC derivatives transactions internationally.Thomson Reuters Practical Law (N.D.), ‘ISDA Master Agreement’.