A derivative is a financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. Derivatives are contracts between two or more parties that specify conditions, such as the dates, resulting values, and definitions of the underlying variables, under which payments are to be made between the parties). The underlying assets can include commodities, stocks, bonds, interest rates, currencies, or other derivatives, which adds another layer of complexity to proper valuation). Derivatives are one of the three main categories of financial instruments, the other two being equity (i.e., stocks or shares) and debt (i.e., bonds and mortgages) ).
Derivatives can be traded on an exchange or over-the-counter, and their prices derive from fluctuations in the underlying asset. They are usually leveraged instruments, which increases their potential risks and rewards. Common types of derivatives include futures contracts, forwards, options, and swaps. Futures contracts involve two parties agreeing to buy and sell an asset at a set price on a future date, while options give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified time period. Forwards are similar to futures, but they are not standardized and are traded over-the-counter. Swaps involve exchanging cash flows based on different financial instruments, such as interest rates or currencies.
Derivatives are used for two main purposes: to speculate and to hedge investments. Speculators use derivatives to make bets on the future direction of an assets price, while investors use them to hedge against potential losses in their portfolios. However, derivatives can be complex and involve significant risks, making them unsuitable for less experienced investors.
