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 purpose of a hedge fund?

    Find out what a hedge fund is, how it is set up and why it is different than other forms of investment partnerships like ...
  2. How do futures contracts roll over?

    Learn about why futures contracts are often rolled over into forward month contracts prior to expiration, and understand ...
  3. How are American Depository Receipts (ADRs) priced?

    Understand what American depositary receipts are and how they work, including how the price of ADRs is determined by the ...
  4. How does a forward contract differ from a call option?

    Find out more about forward contracts, call options, the mechanics of these financial instruments and the difference between ...
RELATED TERMS
  1. Strike Width

    The difference between the strike price of an option and the ...
  2. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  3. Reference Equity

    The underlying equity that an investor is seeking price movement ...
  4. Boundary Conditions

    The maximum and minimum values used to indicate where the price ...
  5. Bear Closing

    Purchasing a security, currency, or commodity in order to close ...
  6. Best To Deliver

    The security that is delivered by the short position holder in ...

You May Also Like

Related Articles
  1. Mutual Funds & ETFs

    What is the purpose of a hedge fund?

  2. Investing Basics

    How To Create Capital Protected Investment ...

  3. Investing Basics

    Bitcoin ETFs: How Do They Work?

  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB US Dollar

  5. Mutual Funds & ETFs

    Why Mutual Funds are Still Better than ...

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!