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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. (For more on derivatives, also check out Derivatives 101.)

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.

Uses for Derivatives

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.

Derivatives Between Two Parties

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, and 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.

Using a basic example, let's assume that in April 2017 the farmer enters a futures contract with a miller to sell 5,000 bushels of wheat at $4.404 per bushel in July. At expiry date in July 2017, if the market price of wheat falls to $4.350, the miller has to buy at the contract price of $4.404 which is much higher than the market price of $4.350. Instead of paying 4.350 x 5000 = $21,750, he'll pay 4.404 x 5000 = $22,020. Lucky farmer gets to sell at a higher price than what the market is offering.

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.

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