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 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 >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. What does it mean to take delivery of a derivative contract?

    Find out more about derivative contracts and what it means when the holders of derivative contracts take delivery of the ... Read Answer >>
Related Articles
  1. Trading

    Derivatives 101

    Learn how to use this type of investment as an alternative way to participate in the market.
  2. 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.
  3. Financial Advisor

    What Is A Derivative?

    A derivative is a security whose price is dependent upon or derived from one or more underlying assets. Learn more on how investors can use this financial instrument in their trading strategies.
  4. Financial Advisor

    Warrants

    Learn more about this derivative security.
  5. Trading

    Careers In The Derivatives Market

    The growing interest in and complexity of these securities means opportunities for job seekers.
  6. Investing

    Buffett Nixes Credit Derivatives From Berkshire Portfolio

    After years of gradually reducing exposure to credit derivatives, Buffett's Berkshire Hathaway finally exits the market completely.
  7. Trading

    Are Derivatives A Disaster Waiting To Happen?

    They've contributed to some major market scandals, but these instruments aren't all bad.
  8. Investing

    How To Invest In Commodities

    Find out which futures, options or funds will be your perfect commodity portfolio fit.
  9. Insights

    Make An Extra $35K A Year In The Most Misunderstood Financial Market

    I want to let you in on a secret: Wall Street doesn't make most of its money from the stock market.#-ad_banner-#While trading equities constitutes a large part of "big banking," if you were to ...
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Underlying Option Security

    An underlying option security is the financial instrument on ...
  3. Derivatives Time Bomb

    A possibile situation where the financial markets plunge into ...
  4. Credit Derivative

    Privately held negotiable bilateral contracts that allow users ...
  5. Price Swap Derivative

    A derivative transaction in which one party guarantees a fixed ...
  6. Economic Derivative

    A relatively new form of derivative contract (the first ones ...
Hot Definitions
  1. Protectionism

    Government actions and policies that restrict or restrain international trade, often done with the intent of protecting local ...
  2. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  3. Demonetization

    Demonetization is the act of stripping a currency unit of its status as legal tender and is necessary whenever there is a ...
  4. Investment

    An asset or item that is purchased with the hope that it will generate income or appreciate in the future. In an economic ...
  5. Redlining

    The unethical practice whereby financial institutions make it extremely difficult or impossible for residents of poor inner-city ...
  6. Nonfarm Payroll

    A statistic researched, recorded and reported by the U.S. Bureau of Labor Statistics intended to represent the total number ...
Trading Center