Definition of Derivative
A derivative is a financial instrument that is based on the value of another asset, known as the underlying asset. Common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Derivatives are mostly used to hedge risk or for speculative purposes, where investors bet on the future direction of the underlying asset’s price.
Examples
Options
An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price before or on a specified date. Options can be used for hedging risk or for speculative strategies.
Futures
A futures contract is an agreement to buy or sell an asset at a future date at a price agreed upon today. Futures are standardized and traded on an exchange, making them highly liquid and transparent.
Swaps
A swap is a derivative contract through which two parties exchange financial instruments, often used to manage exposure to fluctuations in interest rates, currency exchange rates, or commodity prices.
Warrants
Warrants provide the holder the right to purchase the underlying stock of the issuing company at a fixed price until the expiry date. They are often issued by companies as a way to attract more investors.
Rights
Rights are issued to existing shareholders, allowing them to purchase additional shares at a discounted price, which helps companies raise capital more effectively.
Frequently Asked Questions
What is the primary purpose of derivatives? Derivatives are primarily used for hedging risks related to the price movements of the underlying asset and for speculative purposes to take advantage of price changes.
How are derivatives regulated? Derivatives are generally regulated by financial authorities to ensure transparency and reduce systemic risks. For instance, in the United States, the Commodity Futures Trading Commission (CFTC) regulates futures and options markets.
Can derivatives be used for both hedging and speculation? Yes, derivatives can serve both functions. Hedgers use derivatives to manage or mitigate risk, while speculators use them to profit from anticipated changes in the price of the underlying asset.
What is the difference between exchange-traded and over-the-counter (OTC) derivatives? Exchange-traded derivatives are standardized contracts traded on regulated exchanges, which provides greater liquidity and less counterparty risk. OTC derivatives are customized contracts that are traded directly between parties, avoiding the exchange but presenting higher counterparty risks.
Related Terms with Definitions
Hedging: The act of taking a position in a derivative to offset the risk of adverse price movements in an asset.
Speculation: The act of trading in financial instruments, whether derivatives or stocks, with the aim of making a profit from price movements.
Arbitrage: The practice of buying and selling equivalent goods to profit from price discrepancies in different markets or forms.
Underlying Asset: The financial asset upon which a derivative’s price is based.
Leverage: The use of borrowed funds or financial instruments, such as derivatives, to increase the potential return of an investment.
Online Resources
- Investopedia: Derivative
- CFTC: Commodity Futures Trading Commission
- SEC: U.S. Securities and Exchange Commission
References
- Hull, J. C. (2017). Options, Futures, and Other Derivatives. Pearson Education.
- Kolb, R. W., & Overdahl, J. A. (2010). Financial Derivatives: Pricing and Risk Management. Wiley.
Suggested Books for Further Studies
- Derivative Securities by Robert W. Kolb and James A. Overdahl
- Fundamentals of Futures and Options Markets by John C. Hull
- Derivatives Markets by Robert L. McDonald
- The Derivatives Sourcebook by Terence Lim
- Risk Management and Financial Institutions by John C. Hull
