Help! What is a Derivative?

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Derivatives are financial contracts (financial instruments) whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, stocks, residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions). Credit derivatives are based on loans, bonds or other forms of credit.

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.

Three major classes of derivatives:

1. Futures: Contract to buy or sell an asset on or before a future date at a price specified today. It is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold. (Similarly, but with an important difference, a forward contract is a non-standardized contract written by the parties themselves.)

2. Options are contracts that give the owner the right, but not the obligation, to buy or sell an asset. (A call option is an option to buy, a put option is an option to or sell). The price at which the sale takes place is known as the strike price and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction.

3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

Wikipedia is criticised for being unreliable and suceptible to manipulation. But say what you will about Wikipedia, if you want to get a feel for what Financial Derivatives are then take a look at this: Wikipedia - Financial Derivatives

1997 article by Cato Institute seemingly arguing for less regulation of Financial Derivatives: 10 Myths about Derivatives

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