What Is a Derivative?

A derivative is a financial contract whose value depends on, or derives from, the price of something else, called the underlying asset. The underlying can be a stock, an index, a bond, a currency, a commodity, an interest rate, a cryptocurrency or even an event. If the underlying moves, the derivative's value moves with it, often by a multiple.

The main types of derivatives#

Each has its own lesson: What Is a Future?, Forwards vs Futures, What Is an Option?, Swaps Explained, What Is a CFD? and Perpetual Futures.

Why derivatives exist#

Derivatives are often seen as speculative tools, but they began as risk management tools and most of their volume still serves that purpose.

• Hedging. An airline buys oil futures to lock in fuel costs. A pension fund uses interest rate swaps to match its future payments. A stock investor buys puts as insurance. See Hedging.
• Price discovery. Futures markets, which trade almost around the clock, often signal where stock and commodity prices are heading before the underlying markets open.
• Access. Derivatives let traders gain exposure to markets that are hard to trade directly, such as a whole stock index or a commodity that must be stored.
• Leverage and speculation. Because derivatives require only a deposit or premium, traders can take large positions with less capital. This adds liquidity to the market and also risk to the trader.

Exchange traded vs over the counter#

Exchange traded derivatives, such as listed futures and options, have standard terms and are guaranteed by a clearing house, which steps in if one side fails. Prices are public.

Over the counter (OTC) derivatives, such as many swaps and forwards, are private contracts between two parties. They can be tailored but carry counterparty risk: the chance the other side cannot pay. Since the 2008 crisis, many standard OTC derivatives must be cleared centrally and reported to regulators. See Clearing Houses and Central Counterparties and Market, Credit and Counterparty Risk.

How leverage works in derivatives#

This is the core idea: derivatives multiply exposure relative to the money put up, which magnifies results in both directions. See Leverage.

Risks of derivatives#

• Leverage risk: losses can exceed the initial deposit for futures, CFDs and sold options.
• Complexity: options in particular depend on several factors, including time and volatility, so the position can lose value even if the underlying moves the right way.
• Liquidity risk: some contracts trade thinly, especially far from the current price or date.
• Counterparty risk: for OTC contracts and offshore brokers.
• Expiry: most derivatives have a deadline, so timing matters as well as direction.

Warren Buffett famously called derivatives "financial weapons of mass destruction" in a 2002 letter to shareholders, referring to the hidden risks of large OTC positions. The same tools, used with clear limits, are also how farmers, airlines and fund managers protect themselves every day.

Every derivative is built on a legal agreement between two sides; the What Is a Contract? lesson explains what a contract specifies and why standardisation matters.

Frequently asked questions#

Are derivatives only for professionals?#

No. Listed options and futures are available to individuals through brokers, often after an approval process. They do require understanding before use.

Is a stock a derivative?#

No. A stock is direct ownership in a company. Options and futures on that stock are derivatives.

Why are derivatives considered risky?#

Because they often involve leverage and can lose value quickly, sometimes more than the amount invested. The risk depends on how they are used.

Sources#

• U.S. Commodity Futures Trading Commission, Learn and protect
• Wikipedia, Derivative (finance)