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Derivative (Investing)

Moneyzine Editor
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Moneyzine Editor
1 mins
January 16th, 2024
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Derivative (Investing)

Definition

The term derivative refers to a financial contract that derives a portion of its value and characteristics from an underlying asset. Derivatives have no value other than the expected future price movements of the underlying asset.

Explanation

As the name implies, a derivative derives its value from another asset. It is a contract between two or more parties and the underlying asset may include a bond, commodity, currency, foreign exchange rate, equity, index, or even interest rate and weather. Some of the more common uses of derivatives include:

  • Hedging or mitigating risk in the underlying asset

  • Providing leverage or gearing, thereby increasing the trader's exposure to relatively small price movements without a large capital outlay

  • Creating optionality with respect to trading the underlying asset

  • Obtaining exposure to the underlying asset, when it cannot be traded directly

  • Increasing exposure to price movements

  • Speculation

Examples of derivatives include credit default swaps, collateralized debt obligations, forward contracts, futures contracts, options, swaps, and warrants. While the term is oftentimes associated with speculation, derivatives provide an important role in helping companies to control volatility in their raw materials cost.

Related Terms

  • Equivalent Strategy (Options)
    The term equivalent strategy refers to two positions that share the same risk and reward profile. When two traders assume different, but equivalent strategies, they will share the same payoff.
    Moneyzine Editor
    Moneyzine Editor
    January 17th, 2024
  • Equity Option
    The term equity option refers to a call or put involving an individual common stock or exchange traded fund (ETF). Equity options are considered equity derivatives and are the most common type of this contract.
    Moneyzine Editor
    Moneyzine Editor
    January 17th, 2024
  • Early Exercise (Options)
    The term early exercise refers to a feature of American options that permit the holder to exercise the option prior to its expiration date. While most index options are of the European-style, options involving equities are typically of the American-style.
    Moneyzine Editor
    Moneyzine Editor
    January 16th, 2024
  • Diagonal Spread
    The term diagonal spread refers to a strategy that involves the simultaneous purchase and writing of two options of the same type with different strike prices and expiration dates. Diagonal spreads also involve the same underlying asset.
    Moneyzine Editor
    Moneyzine Editor
    January 16th, 2024

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