what is a derivative 
the term derivative refers to a type of financial contract whose value is dependent on an underlying asset group of assets or benchmark a derivative is set between two or more parties that can trade on an exchange or over the counter otc these contracts can be used to trade any number of assets and carry their own risks prices for derivatives derive from fluctuations in the underlying asset these financial securities are commonly used to access certain markets and may be traded to hedge against risk derivatives can be used to either mitigate risk hedging or assume risk with the expectation of commensurate reward speculation derivatives can move risk and the accompanying rewards from the risk averse to the risk seekers investopedia katie kerpelunderstanding derivativesa derivative is a complex type of financial security that is set between two or more parties derivatives can take many forms from stock and bond derivatives to economic indicator derivatives traders use derivatives to access specific markets and trade different assets typically derivatives are considered a form of advanced investing the most common underlying assets for derivatives are stocks bonds commodities currencies interest rates and market indexes contract values depend on changes in the prices of the underlying asset the primary instrument derivatives can be used to hedge a position speculate on the directional movement of an underlying asset or give leverage to holdings these assets are commonly traded on exchanges or otc and are purchased through brokerages the chicago mercantile exchange cme is among the world s largest derivatives exchanges 1it s important to remember that when companies hedge they re not speculating on the price of the commodity instead the hedge is merely a way for each party to manage risk each party has its profit or margin built into the price and the hedge helps to protect those profits from being eliminated by market moves in the price of the commodity otc traded derivatives generally have a greater possibility of counterparty risk which is the danger that one of the parties involved in the transaction might default these contracts trade between two private parties and are unregulated to hedge this risk the investor could purchase a currency derivative to lock in a specific exchange rate derivatives that could be used to hedge this kind of risk include currency futures and currency swaps exchange traded derivatives are standardized and more heavily regulated than those that are traded over the counter special considerationsderivatives were originally used to ensure balanced exchange rates for internationally traded goods international traders needed a system to account for the differing values of national currencies assume a european investor has investment accounts that are all denominated in euros eur let s say they purchase shares of a u s company through a u s exchange using u s dollars usd this means they are now exposed to exchange rate risk while holding that stock exchange rate risk is the threat that the value of the euro will increase in relation to the usd if this happens any profits the investor realizes upon selling the stock become less valuable when they are converted into euros a speculator who expects the euro to appreciate versus the dollar could profit by using a derivative that rises in value with the euro when using derivatives to speculate on the price movement of an underlying asset the investor does not need to have a holding or portfolio presence in the underlying asset many derivative instruments are leveraged which means a small amount of capital is required to have an interest in a large amount of value in the underlying asset types of derivativesderivatives today are based on a wide variety of transactions and have many more uses there are even derivatives based on weather data such as the amount of rain or the number of sunny days in a region there are many different types of derivatives that can be used for risk management speculation and leveraging a position the derivatives market is one that continues to grow offering products to fit nearly any need or risk tolerance there are two classes of derivative products lock and option lock products e g futures forwards or swaps bind the respective parties from the outset to the agreed upon terms over the life of the contract option products e g stock options on the other hand offer the holder the right but not the obligation to buy or sell the underlying asset or security at a specific price on or before the option s expiration date the most common derivative types are futures forwards swaps and options a futures contract or simply futures is an agreement between two parties for the purchase and delivery of an asset at an agreed upon price at a future date futures are standardized contracts that trade on an exchange traders use a futures contract to hedge their risk or speculate on the price of an underlying asset the parties involved are obligated to fulfill a commitment to buy or sell the underlying asset for example say that on nov 6 2021 company a buys a futures contract for oil at a price of 62 22 per barrel that expires dec 19 2021 the company does this because it needs oil in december and is concerned that the price will rise before the company needs to buy buying an oil futures contract hedges the company s risk because the seller is obligated to deliver oil to company a for 62 22 per barrel once the contract expires assume oil prices rise to 80 per barrel by dec 19 2021 company a can accept delivery of the oil from the seller of the futures contract but if it no longer needs the oil it can also sell the contract before expiration and keep the profits in this example both the futures buyer and seller hedge their risk company a needed oil in the future and wanted to offset the risk that the price may rise in december with a long position in an oil futures contract the seller could be an oil company concerned about falling oil prices that wanted to eliminate that risk by selling or shorting a futures contract that fixed the price it would get in december it is also possible that one or both of the parties are speculators with the opposite opinion about the direction of december oil in that case one might benefit from the contract and one might not take for example the futures contract for west texas intermediate wti oil that trades on the cme and represents 1 000 barrels of oil if the price of oil rose from 62 22 to 80 per barrel the trader with the long position the buyer in the futures contract would have profited 17 780 80 62 22 x 1 000 17 780 2 the trader with the short position the seller in the contract would have a loss of 17 780 not all futures contracts are settled at expiration by delivering the underlying asset if both parties in a futures contract are speculating investors or traders it is unlikely that either of them would want to make arrangements for the delivery of a large number of barrels of crude oil speculators can end their obligation to purchase or deliver the underlying commodity by closing unwinding their contract before expiration with an offsetting contract many derivatives are in fact cash settled which means that the gain or loss in the trade is simply an accounting cash flow to the trader s brokerage account futures contracts that are cash settled include many interest rate futures stock index futures and more unusual instruments such as volatility futures or weather futures forward contracts or forwards are similar to futures but they do not trade on an exchange these contracts only trade over the counter when a forward contract is created the buyer and seller may customize the terms size and settlement process as otc products forward contracts carry a greater degree of counterparty risk for both parties counterparty risks are a type of credit risk in that the parties may not be able to live up to the obligations outlined in the contract if one party becomes insolvent the other party may have no recourse and could lose the value of its position once created the parties in a forward contract can offset their position with other counterparties which can increase the potential for counterparty risks as more traders become involved in the same contract swaps are another common type of derivative often used to exchange one kind of cash flow with another for example a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan or vice versa imagine that company xyz borrows 1 000 000 and pays a variable interest rate on the loan that is currently 6 xyz may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable rate risk assume xyz creates a swap with company qrs which is willing to exchange the payments owed on the variable rate loan for the payments owed on a fixed rate loan of 7 that means that xyz will pay 7 to qrs on its 1 000 000 principal and qrs will pay xyz 6 interest on the same principal at the beginning of the swap xyz will just pay qrs the 1 percentage point difference between the two swap rates if interest rates fall so that the variable rate on the original loan is now 5 company xyz will have to pay company qrs the 2 percentage point difference on the loan if interest rates rise to 8 then qrs would have to pay xyz the 1 percentage point difference between the two swap rates regardless of how interest rates change the swap has achieved xyz s original objective of turning a variable rate loan into a fixed rate loan swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a loan or cash flows from other business activities swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative in fact they ve been a bit too popular in the past it was the counterparty risk of swaps like this that eventually spiraled into the credit crisis of 2008 an options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price the key difference between options and futures is that with an option the buyer is not obliged to exercise their agreement to buy or sell it is an opportunity only not an obligation as futures are as with futures options may be used to hedge or speculate on the price of the underlying asset in terms of timing your right to buy or sell it depends on the style of the option an american option allows holders to exercise the option rights at any time before and including the day of expiration a european option can be executed only on the day of expiration most stocks and exchange traded funds have american style options while equity indexes including the s p 500 have european style options 