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Derivative
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What is a 'Derivative'
Derivative:MyFavoriteFinancialTerm
A derivative is asecurity
asecuritywith
with a price that is dependent upon or derived from
one or more underlying assets
assets.. The derivative itself is a contract between
two or more parties based upon the asset or assets. Its value is determined
by fluctuations in the underlying asset. The most common underlying assets
include stocks
stocks,, bonds
bonds,, commodities
commodities,, currencies
currencies,, interest rates and market
indexes..
indexes

Derivatives either be traded over-the-counter (OTC) or on an exchange
exchange.. OTC
derivatives constitute the greater proportion of derivatives in existence and
are unregulated, whereas derivatives traded on exchanges are standardized.
OTC derivatives generally have greater risk for the counterparty than do
00:00 01:08
standardized derivatives.

BREAKING DOWN 'Derivative'

Originally, derivatives were used to ensure balanced exchange rates for goods traded
internationally. With differing values of different national currencies,
currencies, international traders needed a
system of accounting for these differences. Today, derivatives are based upon a wide variety of
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transactions and have many more uses. There are evenderivatives
evenderivatives based on weather data,
data, such as
the amount of rain or the number of sunny days in a particular region.

Because a derivative is a category of security rather than a specific kind, there are several different
kinds of derivatives in existence. As such, derivatives have a variety of functions and applications as
well, based on the type of derivative. Certain kinds of derivatives can be used for hedging
hedging,, or
insuring against risk on an asset. Derivatives can also be used for speculation in betting on the future
price of an asset or in circumventing exchange rate issues. For example, a European investor
purchasing shares of an American company off of an American exchange (using U.S. dollars to do so)
would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor
could purchase currency futures to lock in a specified exchange rate for the future stock sale and
currency conversion back into Euros
Euros.. Additionally, many derivatives are characterized by
highleverage
highleverage..

Common Forms of 'Derivative'

Futures contracts are one of the most common types of derivatives. A futures contract (or
simplyfutures
simply futures,, colloquially) is an agreement between two parties for the sale of an asset at an
agreed upon price. One would generally use a futures contract to hedge against risk during a
particular period of time. For example, suppose that on July 31, 2014 Diana owned ten thousand
shares of Wal-Mart (WMT
(WMT)) stock, which were then valued at $73.58 per share
share.. Fearing that the value
of her shares would decline, Diana decided that she wanted to arrange a futures contract to protect
the value of her stock. Jerry, a speculator predicting a rise in the value of Wal-Mart stock, agrees to a
futures contract with Diana, dictating that in one years time Jerry will buy Dianas ten thousand
Wal-Mart shares at their current value of $73.58.

The futures contract may in part be considered to be something like a bet between the two parties. If
the value of Dianas stock declines, her investment is protected because Jerry has agreed to buy
them at their July 2014 value, and if the value of the stock increases, Jerry earns greater value on the
stock, as he is paying July 2014 prices for stock in July 2015. A year later, July 31 rolls around and
Wal-Mart is valued at $71.98 per share. Diana, then, has benefited from the futures contract, making
$1.60 more per share than she would have if she had simply waited until July 2015 to sell her stock.
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While this might not seem like much, this difference of $1.60 per share translates to a difference of
$16,000 when considering the ten thousand shares that Diana sold. Jerry, on the other hand, has
speculated poorly and lost a sizeable sum.

Forward contracts are another important kind of derivative similar to futures contracts, the key
difference being that unlike futures, forward contracts (or forwards) are not traded on exchange,
but rather are only traded over-the-counter.
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Swaps are another common type of derivative. A swap is most often a contract between two parties
agreeing to trade loan terms. One might use an interest rate swap in order to switch from a variable
interest rate loan to a fixed interest rate loan, or vice versa. If someone with a variable interest rate
loan were trying to secure additional financing, a lender might deny him or her a loan because of the
uncertain future bearing of the variable interest rates upon the individuals ability to repay debts
debts,,
perhaps fearing that the individual will default
default.. For this reason, he or she might seek to switch their
variable interest rate loan with someone else, who has a loan with a fixed interest rate that is
otherwise similar. Although the loans will remain in the original holders names, the contract
mandates that each party will make payments toward the others loan at a mutually agreed upon
rate. Yet, this can be risky, because if one party defaults or goes bankrupt
bankrupt,, the other will be forced
back into their original loan. Swaps can be made using interest rates, currencies or commodities.

Options are another common form of derivative. An option is similar to a futures contract in that it is
an agreement between two parties granting one the opportunity to buy or sell a security from or to
the other party at a predetermined future date. Yet, the key difference between options and futures
is that with an option the buyer or seller is not obligated to make the transaction if he or she decides
not to, hence the name option. The exchange itself is, ultimately, optional. Like with futures,
options may be used to hedge the sellers stock against a price drop and to provide the buyer with
an opportunity for financial gain through speculation. An option can be short or long
long,, as well as a
call or put
put..
A credit derivative is yet another form of derivative. This type of derivative is a loan sold to a
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speculator at a discount to its true value. Though the original lender is selling the loan at a reduced
price, and will therefore see a lower return
return,, in selling the loan the lender will regain most of the
capital from the loan and can then use that money to issue a new and (ideally) more profitable loan.
If, for example, a lender issued a loan and subsequently had the opportunity to engage in another
loan with more profitable terms, the lender might choose to sell the original loan to a speculator in
order to finance the more profitable loan. In this way, credit derivatives exchange modest returns for
lower risk and greater liquidity
liquidity..

Another form of derivative is a mortgage-backed security,

security, which is a broad category of derivative
simply defined by the fact that the assets underlying the derivative are mortgages
mortgages..

Limitations of Derivatives
As mentioned above, derivative is a broad category of security, so using derivatives in making
financial decisions varies by the type of derivative in question. Generally speaking, the key to
making a sound investment is to fully understand the risks associated with the derivative, such as
the counterparty, underlying asset,
asset, price and expiration
expiration.. The use of a derivative only makes sense if
the investor is fully aware of the risks and understands the impact of the investment within a
portfolio strategy
strategy..

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Exchange Traded
Derivative
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An exchange traded derivative is a financial instrument whose value is based on the value of another
asset, and that trades on a regulated exchange. Exchange traded derivatives have become
increasingly popular because of the advantages they have over over-the-counter (OTC) derivatives,
such as standardization
standardization,, liquidity
liquidity,, and elimination of default risk.
risk. Futures and options are two of the
most popular exchange traded derivatives. These derivatives can be used to hedge exposure or
speculate on a wide range of financial assets like commodities, equities
equities,, currencies
currencies,, and even
interest rates.

BREAKING DOWN 'Exchange Traded Derivative'

Exchange traded derivatives are especially suited for the retail investor because of the following
features that distinguish them from OTC derivatives -

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