Derivative instruments definition
/What are Derivative Instruments?
A derivative is a financial instrument that has the following characteristics:
It is a financial instrument or a contract that requires either a small or no initial investment;
There is at least one notional amount (the face value of a financial instrument, which is used to make calculations based on that amount) or payment provision;
It can be settled net, which is a payment that reflects the net difference between the ending positions of the two parties; and
Its value changes in relation to a change in an underlying, which is a variable, such as an interest rate, exchange rate, credit rating, or commodity price, that is used to determine the settlement of a derivative instrument. The value of a derivative can even change in conjunction with the weather.
A financial instrument is a document that has monetary value or which establishes an obligation to pay. Examples of financial instruments are cash, foreign currencies, accounts receivable, loans, bonds, equity securities, and accounts payable.
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How Derivative Instruments are Used
In essence, a derivative constitutes a bet that something will increase or decrease. As such, a derivative can be used in two ways. Either it is a tool for avoiding risk, or it is used to speculate. In the former case, derivatives are used to offset expected changes in the value of an asset or liability, so that the net effect is zero. In the latter case, an entity accepts risk in order to possibly earn above-average profits. Speculation using derivatives can be extremely risky, since a large adverse movement in an underlying could trigger a massive liability for the holder of a derivative.
Examples of Derivative Instruments
Examples of derivatives include the following:
Call option. An agreement that gives the holder the right, but not the obligation, to buy shares, bonds, commodities, or other assets at a predetermined price within a predefined time period.
Put option. An agreement that gives the holder the right, but not the obligation, to sell shares, bonds, commodities, or other assets at a predetermined price within a predefined time period.
Forward. An agreement to buy or sell an asset at a predetermined price as of a future date. This is a highly customizable derivative, which is not traded on an exchange.
Futures. An agreement to buy or sell an asset at a predetermined price as of a future date. This is a standardized agreement, so that they can be more easily traded on a futures exchange.
Swap. An agreement to exchange one security for another, with the intent of altering the security terms to which each party individually is subjected.