What is Derivative?

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DEFINITION:

A derivative is a financial contract whose value is based on the price changes or statistical fluctuations of another asset called an underlying asset.

Understanding derivatives

A derivative is a contract whose value depends on something else. Derivatives derive their value from price movements, events, or outcomes of an underlying asset. Underlyings are usually securities such as stocks, bonds, index funds, mutual funds, and commodities. Derivatives may also track numerical indexes or statistics based on events and outcomes outside of finance – such as the weather. Derivative financial products come in different forms and with different objectives. Some seek to hedge a future price for a commodity, such as wheat, to limit the risk of future price increases. Others speculate on future stock price movements to make a profit. Still others swap currencies and interest rates to gain a comparative advantage. The most important thing about derivatives is that they cannot exist without underlying assets.

EXAMPLE

Extreme weather changes can impact a utility’s bottom line. Weather derivatives provide a way for companies whose business value depends on weather conditions to hedge against the risk of severe or unexpected weather changes. Some weather derivatives derive their value from temperature fluctuations. For example, a weather derivative that relates to temperature could pay the contract holder if the temperature is above a certain level for a specified period of time, which could increase electricity costs. Such a contract could hedge the risk of volatility in energy costs during periods of increased temperatures.

Takeaway

Derivatives trading is like an escalator compared to the staircase of the traditional stock and bond markets…

But escalators go both ways. Derivatives can provide investors with more opportunities for speculation and higher profits. But that opportunity also exposes traders to increased losses. Traders who are particularly risk averse may be better off taking the stairs.

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