What Is a Derivative?

What Is a Derivative?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

A derivative, in financial terms, is a contract or a financial instrument that obtains its value based on the value of another asset. These underlying assets can include bonds, commodities, currencies, interest rates, market indexes, or stocks. They are often used for hedging risk, or for speculative trading. The most common forms of derivatives are futures, options, forwards, and swaps.

Related Questions

1. What are the types of derivatives?

The main types of derivatives are futures, options, swaps, and forward contracts. Future contracts are agreements to buy or sell an asset at a specific date in the future at a predetermined value. Options grant the buyer the right to buy or sell an asset at a set price on or before a specific date. Swaps are agreements between two parties to exchange sequences of cash flows for a set period. Forward contracts are similar to futures but they are private agreements between two parties and not standardized.

2. How do derivatives work?

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Derivatives work through contracts between parties that specify the conditions under which payments, or the exchange of assets, are to be made. The terms of a derivative contract define the underlying asset, the parties involved, the transaction date, and the maturity date. The price of a derivative is driven by the spot price of the underlying asset.

3. Why are derivatives important?

Derivatives offer significant benefits. They can be used to hedge risk, reducing the possibility of significant losses due to fluctuations in the price of an underlying asset. Traders and investors use derivatives to speculate, profiting from the fluctuation in the asset’s price. Plus, derivatives improve market efficiency for the underlying asset by revealing important information about future price expectations and the risk associated with the asset.

4. What are the risks of derivatives?

While derivatives can be used to manage risk, they also introduce risk. Market risk arises from changes in the price of the underlying asset, interest rates, or exchange rates. Credit risk, on the other hand, comes from the potential failure of one of the parties in fulfilling their contractual obligations. Lastly, there is operational risk stemming from errors in the execution of transactions or inadequate controls.

5. Can anyone trade derivatives?

Derivatives trading, while open to anyone in theory, is typically more suitable for experienced investors and traders due to the high risk and complex nature of these instruments. Beginners should first gain a good understanding of the basics of investing and master risk management tactics before venturing into derivatives trading.