In finance, a derivative is a financial instrument whose value is derived from one or more underlying assets. The derivative itself is just a contract between two parties for future transactions exchanging cash and/or assets. It depends on the value of the transaction, the gain or loss to either party, and depends on the value of other underlying variables at the transaction time. We need to clearly spell out the underlying variables in the contract. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Examples of financial derivatives include futures, forwards, options and swaps. These financial instruments play an important and useful role in hedging and managing risk. For example:
- farmers can use derivatives to hedge against the risk of the price of their wheat falling before it has been harvested; and
- pension funds and insurance companies can use derivatives to hedge against large drops in the value of their portfolios.
Most derivatives are characterized by high leverage — and this makes them risky. Thus, derivatives can pose dangers to the stability of financial markets and the overall economy.
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