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
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 EditorNovember 6th, 2024
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 EditorNovember 6th, 2024
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 EditorJanuary 16th, 2024
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 EditorJanuary 16th, 2024
