Derivative definition
/What is a Derivative?
A derivative is a financial instrument whose value changes in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. It requires either a small or no initial investment, and is settled at a future date. A derivative allows an entity to speculate on or hedge against future changes in market factors at minimal initial cost. Derivatives may be traded over the counter or on a formal exchange.
A non-financial instrument may also be a derivative, as long as it is subject to potential net settlement (not delivering or taking delivery of the underlying non-financial item) and it is not part of an entity's normal usage requirements.
Types of Derivatives
There are several types of commonly-used derivatives, including the following:
Forwards. A forward contract is a private, customizable agreement between two parties to buy or sell an asset at a specified price on a future date. These contracts are traded over-the-counter (OTC), making them subject to counterparty risk. Forwards are commonly used by businesses to hedge against fluctuations in commodity prices, currencies, or interest rates.
Futures. Futures contracts are standardized agreements traded on exchanges to buy or sell an asset at a predetermined price and date. Because they are exchange-traded, they are regulated and typically require margin accounts to manage credit risk. Futures are widely used for hedging and speculative purposes in markets like agriculture, energy, and financial instruments.
Options. An option gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified strike price before or at expiration. Buyers pay a premium for this right, while sellers assume potential obligations. Options are popular for hedging and generating income through complex strategies.
Swaps. A swap is a contract in which two parties exchange cash flows or liabilities from two different financial instruments. The most common types include interest rate swaps and currency swaps, often used by institutions to manage exposure to fluctuating rates or exchange values. These contracts are typically customized and traded OTC.
Credit derivatives. Credit derivatives are financial instruments used to manage exposure to credit risk, such as defaults or downgrades. The most common example is the credit default swap (CDS), which functions like insurance against default on a debt instrument. These tools help investors isolate and transfer credit risk without trading the underlying asset.
Warrants. Warrants are long-term options issued by a company that give the holder the right to buy shares at a specific price before expiration. Unlike exchange-traded options, they are often issued in conjunction with bonds or preferred stock. Warrants can be used to sweeten investment deals or to speculate on a company’s future stock price.
Each of these derivatives allows investors to manage risk, speculate on price changes, or increase leverage in their investment strategies.