Derivative

What Does Derivative Mean? A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

A derivative is a financial instrument whose value depends on underlying variables. The most common derivatives are futures, options, and swaps but may also include other tradeable assets such as a stock or commodity or non-tradeable items such as the temperature (in the case of weather derivatives), the unemployment rate, or any kind of (economic) index. [1] A derivative is essentially a contract whose payoff depends on the behavior of a benchmark.

One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[2]

Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (e.g., forward, option, swap); the type of underlying asset (e.g.,equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile.

Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies.

Usage

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2011)

Derivatives are used by investors to:

level);

provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;

speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain

out;

hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it

Benefits

obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);

create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).

The use of derivatives also has its benefits:

Derivatives facilitate the buying and selling of risk, and many financial professionals consider this to have a positive impact on

the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.

Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has

softened the impact of the economic downturn at the beginning of the 21st century.[citation needed]
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