Loading the player...
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 expiry months are typically available for derivatives?

    Discover more about the derivatives market and learn about the varying expiration months for derivatives in different financial ... Read Answer >>
  2. What is the difference between derivatives and options?

    Learn how options are one type of derivative and how equity options derive their value from a stock, and understand other ... Read Answer >>
  3. How is the price of a derivative determined?

    Learn how different types of derivatives are priced, including how futures contracts are valued and the Black-Scholes option ... Read Answer >>
  4. What does the underlying of a derivative refer to?

    Find out more about derivative securities, what an underlying asset is and what the underlying assets refer to in stock options ... Read Answer >>
  5. What kinds of derivatives are types of forward commitments?

    Learn more about what a derivative is, what a forward commitment is and which types of derivative securities have forward ... Read Answer >>
  6. What does it mean to roll a derivative contract?

    Find out more about derivative securities, how to roll forward a derivative contract and what it means when a derivative ... Read Answer >>
Related Articles
  1. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  2. Trading

    Futures, Derivatives and Liquidity: More or Less Risky?

    Futures and derivatives get a bad rap after the 2008 financial crisis, but these instruments are meant to mitigate market risk.
  3. Financial Advisor

    Warrants

    Learn more about this derivative security.
  4. Trading

    Are Derivatives Safe For Retail Investors?

    These vehicles have gotten a bad rap in the press. Find out whether they deserve it.
  5. Trading

    Why Forward Contracts Are The Foundation Of All Derivatives

    This article expands on the complex structure of derivatives by explaining how an investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward ...
  6. Trading

    Careers In The Derivatives Market

    The growing interest in and complexity of these securities means opportunities for job seekers.
  7. Trading

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  8. Investing

    Corporate Futures: Big Names, Big Risk

    We don't often think of Disney and derivatives, but it is one of many companies that use derivatives to hedge risks.
  9. Trading

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  10. Financial Advisor

    SEC Derivatives Rule May Limit Diversification

    The SEC has proposed rules that will limit the use of derivatives by fund managers. Critics believe the rules will impede funds' ability to diversify.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Exchange Traded Derivative

    A financial instrument whose value is based on the value of another ...
  3. Underlying Asset

    A term used in derivatives trading, such as with options. A derivative ...
  4. Underlying Option Security

    An underlying option security is the financial instrument on ...
  5. Underlying Security

    The security on which a derivative derives its value. For example, ...
  6. Equity Derivative

    A derivative instrument with underlying assets based on equity ...
Hot Definitions
  1. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such ...
  2. Death Taxes

    Taxes imposed by the federal and/or state government on someone's estate upon their death. These taxes are levied on the ...
  3. Retained Earnings

    Retained earnings is the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested ...
  4. Demand Elasticity

    In economics, the demand elasticity refers to how sensitive the demand for a good is to changes in other economic variables. ...
  5. Dark Pool

    A dark pool is a private financial forum or exchange for trading securities.
  6. Quadruple Witching

    The expiration date of various stock index futures, stock index options, stock options and single stock futures. All stock ...
Trading Center