The term derivative refers to a financial contract that derives a portion of its value and characteristics from an underlying asset. Derivatives have no value other than the expected future price movements of the underlying asset.
As the name implies, a derivative derives its value from another asset. It is a contract between two or more parties and the underlying asset may include a bond, commodity, currency, foreign exchange rate, equity, index, or even interest rate and weather. Some of the more common uses of derivatives include:
- Hedging or mitigating risk in the underlying asset
- Providing leverage or gearing, thereby increasing the trader’s exposure to relatively small price movements without a large capital outlay
- Creating optionality with respect to trading the underlying asset
- Obtaining exposure to the underlying asset, when it cannot be traded directly
- Increasing exposure to price movements
Examples of derivatives include credit default swaps, collateralized debt obligations, forward contracts, futures contracts, options, swaps, and warrants. While the term is oftentimes associated with speculation, derivatives provide an important role in helping companies to control volatility in their raw materials cost.