What Is a Derivative?

A derivative is a financial instrument that has a value determined by the value of its underlying asset, such as a currency or equity index. Broadly speaking, there are two distinct groups of derivative contracts, which are distinguished by the way they are traded: exchange-traded and over-thecounter (OTC).

1. Value of derivative closely linked to value of underlying asset
2. Derivatives do not include ownership of the asset
3. Stocks differ from derivatives because stocks represent ownership

Since the 1970s, derivatives have become just as important as stock and bonds for investors and finance professionals. Derivatives are an important tool for most companies to protect production costs, hedge foreign exchange risk and compensate employees.

A derivative is a financial instrument that has a value determined by the price of something else that has its own inherent valuation, called the underlying asset or the underlying. The value of the derivative is closely linked to the value of the underlying asset.

There are three major classes of derivatives:

• Futures/Forwards, which are contracts to buy or sell an underlying asset at a specified future date at a specified price
• Options, which are contracts that give a holder (or buyer) the right to buy or sell an asset at a specified future date at a specified price
• Swaps, in which two parties agree to exchange cash flows

Derivatives are different from equities. Fundamentally, a stock gives the holder ownership (equity) in the company issuing the stock. So although stocks and derivatives are both assets, the important distinction is that derivatives do not represent ownership.

Derivatives typically are used to gain exposure to the underlying asset and the movements in its price, without owning the asset. This is key. Derivatives are used to either:

• Hedge--Reduce the risk of losing money from a movement in the underlying asset, or
• Speculate--Make money by a movement in the underlying asset