What is a derivative?

By Jean Folger AAA
A:

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes and stocks.

Futures contracts, forward contracts, options, swaps and warrants are common derivatives. A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract. Similarly, a stock option is a derivative because its value is "derived" from that of the underlying stock.

Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index or security. For example, a trader may attempt to profit from an anticipated drop in an index's price by selling (or going "short") the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset's price to be transferred between the parties involved in the contract.

For example, commodity derivatives are used by farmers and millers to provide a degree of "insurance." The farmer enters the contract to lock in an acceptable price for the commodity; the miller enters the contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change. For example, while the farmer locks in a specified price for the commodity, prices could rise (due to, for instance, reduced supply because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop and the miller will have to pay more for the commodity than he otherwise would have.

Some derivatives are traded on national securities exchanges and are regulated by the U.S. Securities and Exchange Commission (SEC). Other derivatives are traded over-the-counter (OTC); these derivatives represent individually negotiated agreement between parties.

RELATED FAQS

  1. What happens to a company's stocks and bonds when it declares chapter 11 bankruptcy ...

    Filing for chapter 11 bankruptcy protection simply means that a company is on the verge of bankruptcy, but believes that ...
  2. How long can you short sell for?

    When an investor or trader enters a short position, he or she does so with the intention of profiting from falling prices. ...
  3. What's the best way to play backwardation in the futures market?

    Backwardation is a market condition in which a futures contract far from its delivery date is trading at a lower price than ...
  4. What is the difference between shorting and naked shorting?

    Short selling involves borrowing shares of a company’s stock and selling it with the hopes it can be bought back at ...
RELATED TERMS
  1. Multibank Holding Company

    A company that owns or controls two or more banks. Mutlibank ...
  2. Short Put

    A type of strategy regarding a put option, which is a contract ...
  3. Cash-And-Carry Trade

    A trading strategy in which an investor buys a long position ...
  4. Wingspread

    To maximize potential returns for certain levels of risk (while ...
  5. Short Call

    A type of strategy regarding a call option, which is a contract ...
  6. Volatility Smile

    A u-shaped pattern that develops when an option’s implied volatility ...
comments powered by Disqus
Related Articles
  1. The Better Inflation Hedge: Gold or ...
    Investing News

    The Better Inflation Hedge: Gold or ...

  2. How To Buy Oil Options
    Options & Futures

    How To Buy Oil Options

  3. Don't Be Misled By Investment Advertising
    Home & Auto

    Don't Be Misled By Investment Advertising

  4. An Introduction To Depreciation
    Active Trading

    An Introduction To Depreciation

  5. The Over-The-Counter Market: An Introduction ...
    Investing

    The Over-The-Counter Market: An Introduction ...

Trading Center