Derivative
IntermediateA derivative is a financial contract whose value depends on, or is derived from, the price of something else, such as a share, bond, currency, commodity or interest rate.
A derivative does not have value on its own. Its value comes from an underlying asset. If the price of the underlying asset changes, the value of the derivative changes too.
The main types are forwards and futures, which are agreements to buy or sell an asset at a set price on a future date; options, which give the right but not the obligation to buy or sell at a set price; and swaps, which exchange one stream of payments for another, such as fixed interest for floating interest.
Derivatives are used for two main purposes. Hedging means using them to reduce risk. An airline worried about rising fuel prices might agree today on a fixed price for fuel it will buy next year. Speculation means using them to bet on price movements, often with leverage, so small price changes can produce large gains or losses.
For example, a farmer might sell wheat futures before harvest to lock in a price of 250 per tonne, protecting against a fall in prices.
Derivatives can be powerful tools, but they can also be complex and risky. Losses on poorly understood derivatives have contributed to major financial failures.
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