What Is a Derivative?

A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, hobby rates, and market indexes. These assets are frequently purchased thru brokerages.

Derivatives can exchange over-the-counter (OTC) or on an exchange. OTC derivatives constitute a larger proportion of the derivatives market. OTC-traded derivatives, typically have a greater possibility of counterparty risk. Counterparty risk is the chance that one of the parties concerned in the transaction may default. These parties trade between two private parties and are unregulated.

Conversely, derivatives that are exchange-traded are standardized and more heavily regulated.

The Basics of a Derivative

Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. Their value comes from the fluctuations of the values of the underlying asset.

Originally, derivatives were used to make certain balanced exchange rates for goods traded internationally. With the differing values of national currencies, international traders needed a system to account for differences. Today, derivatives are based upon a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the quantity of rain or the number of sunny days in a region.

For example, imagine a European investor, whose investment accounts are all denominated in euros (EUR). This investor purchases shares of a U.S. company via a U.S. exchange using U.S. dollars (USD). Now the investor is exposed to exchange-rate risk whilst holding that stock. Exchange-rate chance the threat that the value of the euro will increase in relation to the USD. If the value of the euro rises, any profits the investor realizes upon selling the stock become much less valuable when they are converted into euros.

To hedge this risk, the investor could purchase a currency derivative to lock in a specific trade rate. Derivatives that could be used to hedge this kind of risk encompass currency futures and currency swaps.

A speculator who expects the euro to recognize in contrast to the dollar ought to income by the use of a spinoff that rises in price with the euro. When the usage of derivatives to speculate on the rate movement of an underlying asset, the investor does now not want to have a preserving or portfolio presence in the underlying asset.

Key Takeaways

– Derivatives are securities that derive their value from an underlying asset or benchmark.
– Common derivatives include futures contracts, forwards, options, and swaps.
– Most derivatives are not traded on exchanges and are used by establishments to hedge risk or speculate on price changes in the underlying asset.
– Exchange-traded derivatives like futures or stock options are standardized and eliminate or reduce  many of the risks of over-the-counter derivatives
– Derivatives are commonly leveraged instruments, which will increase their potential risks and rewards.