Glossary
Derivative
A contract whose value depends on another asset, rate or index, such as options, futures and swaps.
On this page
A derivative is a financial contract whose value is derived from something else, called the Underlying asset: a stock, an index, a bond, a currency, a commodity, an interest rate or even the weather. The contract itself produces nothing; it is a set of promises about future payments that depend on how the underlying moves.
The main types
- Options give the buyer the right, but not the obligation, to buy or sell the underlying at a set price before or at expiry.
- Futures oblige both sides to trade a standardized amount at a set price on a future date, through an exchange and a clearinghouse.
- Forwards are similar but privately negotiated and not exchange traded.
- Swaps exchange one stream of payments for another, such as a fixed interest rate for a floating one; a Credit Default Swap (CDS) is a swap on default risk.
Why they exist
Derivatives let businesses and investors Hedge risks, take positions with little upfront capital, and trade views on volatility or rates that would be hard to express otherwise.
The risks
The same features that make derivatives useful make them dangerous. Most carry Leverage: a small move in the underlying can wipe out the whole investment or, for sellers of options and holders of futures, more than it. Over-the-counter contracts add counterparty risk, the chance the other side cannot pay, which helped turn the 2008 mortgage losses into a wider crisis. Many contracts also expire, so being right about direction but wrong about timing can still lose money.