What is a Derivative?

Published by Thomas Herold in Investments, Trading

'Derivative' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

In the financial world, derivatives are agreements between two different parties that contain values that are dependent on the price movements of an asset, as anticipated in the future, to which they are linked.

This asset, which might be a currency, stock price, or other element is referred to as the underlying. Derivatives are also alternative investments and financial instruments, of which they are numerous kinds. The most common forms of derivatives are futures, swaps, and options.

Investors use derivatives for many different activities. These include for gaining leverage on an investment so that when a small movement occurs in the value of the underlying, they can realize a great gain in the derivative value.

They may also be employed for speculation to profit from, assuming that the underlying asset value goes in the direction that they anticipate. Businesses might similarly hedge their risks in an underlying through opening a derivative contract that moves conversely to their position in the underlying, canceling all or part of the risk in the process. Investors similarly are capable of gaining exposure to an underlying that does not have a tradable instrument associated with it, like with a weather derivative.

Investors can also utilize derivatives to give themselves the ability to create options in which the derivative value is associated with a particular event or condition being met.

Derivatives principally remain a means of offering hedging insurance, allowing one party to lessen their risk exposure while the other reduces a different kind of risk exposure. Derivatives examples of transferring risk are helpful to consider. Millers and wheat farmers might create a derivative by signing a futures contract. This could specify a certain dollar value of money in exchange for a particular quantity of wheat to be exchanged at a future time. In this case, the two parties have actually diminished their risk for the future. The miller is not exposed to possible shortages of wheat, while the farmer is saved from the possible variances in price.

Risk is not completely eliminated in this example since the derivative contract will not cover events that the contract does not mention in particular, like weather conditions. There is similarly a danger that one of the parties will default on their part of the contract. To mitigate these problems, clearing houses insure many futures contracts, although not every such derivative is insured for the risk of counter party default.

Another way of looking at derivatives in this example is that while they reduce one form of risk, they actually present another one. The miller and farmer both pick up another risk by signing off on this contract. For the farmer, the danger lies in the fact that although he is saved from declines in the price of wheat, he is also exposed to the possibility that wheat prices will rise above the set amount in the contract, costing him extra income that he might have obtained. The miller also picks up a risk that the cost of wheat will drop below the amount that he has locked in with this contract.

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The term 'Derivative' is included in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.