Derivative
What is Derivative?
A derivative is a financial contract whose value is based on the price of an underlying asset like a stock, commodity, or currency.
Common types include futures, options, and swaps. Derivatives are used to hedge risk or to speculate. Heavy, poorly understood derivative use (e.g., mortgage-backed securities) contributed to the 2008 financial crisis.
Derivative: a worked example
Ridgeline Brewing borrows $500,000 at a floating rate, currently 4%, and worries rates will climb. It enters a swap with a bank: Ridgeline pays a fixed 5% on the $500,000 and receives the floating rate in return. If floating rises to 7%, Ridgeline owes its lender 7% of $500,000, or $35,000, receives $35,000 from the swap, and pays the bank $25,000 fixed. Its all-in cost is $25,000, exactly 5%. No loan was bought or sold and no principal moved; the contract's entire value came from where the floating rate went, which is what makes it a derivative.
The mistake students make with derivative
Derivatives get labeled gambling by definition, which misses that the same contract removes risk or adds it depending on who holds it. A farmer selling a crop forward has less exposure afterwards; a trader with no crop selling the identical contract has more. Between the two sides the contract is zero sum, so no risk is created, only transferred. What makes derivatives dangerous is borrowed money and crowding onto one side of the trade, not the instrument itself. Coverage of financial blowups tends to collapse all of that into one word.
Derivative questions
What are the four main types of derivatives?
The four main types of derivatives are forwards, futures, options, and swaps. A forward is a private agreement to trade later at a price set now; a future is that same idea standardized and traded on an exchange with a clearinghouse guaranteeing both sides. An option gives the right without the obligation to trade at a set price. A swap exchanges one payment stream for another, most often floating interest for fixed.
Why do companies use derivatives?
Companies use derivatives to make a future cost or revenue predictable. An airline that fixes its fuel price can set ticket prices months ahead without guessing, and an exporter paid in another currency can lock in the exchange rate it will receive. The aim is not to profit on the contract but to remove one unknown from the budget, and the firm accepts a known cost, the price of the hedge, to do it.
What is the underlying asset in a derivative?
The underlying asset in a derivative is whatever the contract's value is calculated from, and it can be a commodity, a stock, a bond, a currency, an interest rate, or an index. Holding the derivative is not holding the underlying: a wheat futures buyer normally closes the position before any grain is due. The underlying only needs an observable price that both sides agree to reference.
Related terms
Common comparisons
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