Derivative markets offer greater liquidity, lower capital requirements and lower transaction costs than the underlying spot markets.

Arbitrage is the opportunity to buy low and sell high if two equivalent assets or derivatives or combinations of assets and derivatives are sold at different prices, thus earning a risk-free profit without investing any capital. The joint action of arbitrageurs leads to price convergence.

Thus, arbitrage leads to the law of unity: transactions that produce equal outcomes must be sold at equal prices. Price convergence results from a high demand for lower-priced assets and a high supply of higher-priced assets.

A derivative is a financial instrument that derives its value from the performance of the underlying (asset). Simply put, a derivative is a legal contract entered into today between a buyer and a seller for a transaction that will be completed at a specific time in the future. For example, a contract to buy shares of Company XYZ for USD 50 in 6 months is an example of a derivative contract.

An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and a claim is issued against the portfolio in the form of tranches so that prepayments or credit losses are allocated first to the most junior tranche and finally to the most senior tranche. Another definition of a derivative is that it is a financial instrument that changes the performance of the underlying.

Mutual funds do not change the value of the returns on the underlying assets; they simply pass those returns on to the holders. Therefore, they are not derivatives.