Derivative definition
/What is a Derivative?
A derivative is a financial instrument whose value changes in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. It requires either a small or no initial investment, and is settled at a future date. A derivative allows an entity to speculate on or hedge against future changes in market factors at minimal initial cost. Derivatives may be traded over the counter or on a formal exchange.
A non-financial instrument may also be a derivative, as long as it is subject to potential net settlement (not delivering or taking delivery of the underlying non-financial item) and it is not part of an entity's normal usage requirements.
Examples of Derivatives
There are several types of commonly-used derivatives, including the following:
Futures contract. This is an agreement to buy or sell an asset at a predetermined price on a specific future date. For example, oil futures allow investors to lock in the price of oil for a future date. If an airline wants to hedge against rising oil prices, it might buy oil futures to secure a stable price
Options contract. These arrangements give the holder the right, but not the obligation, to buy or sell an asset at a specific price before a certain date. For example, an investor buys a call option on a stock with a strike price of $100, expecting the stock’s price to rise. If the stock goes up to $120, the investor can buy it at $100 and potentially sell it at $120, making a profit.
Swap arrangement. This is an agreement to exchange cash flows or other financial instruments over a period. For example, a company with a floating-rate loan might enter into an interest rate swap to pay a fixed rate and receive a floating rate, thereby stabilizing its interest expenses.
Each of these derivatives allows investors to manage risk, speculate on price changes, or increase leverage in their investment strategies.