Derivative
A financial contract whose value is derived from the price of an underlying asset such as a stock, index, commodity, or currency.
A derivative is a contract between two parties whose payoff depends on the future price of an underlying asset. The underlying can be an equity, index, commodity, interest rate, currency, or even another derivative.
Common forms include futures, forwards, options, and swaps. Derivatives are used for three broad purposes: hedging existing exposure, speculation on directional or volatility moves, and arbitrage between related markets.
Because derivatives are leveraged instruments, gains and losses are magnified relative to the capital deployed.
Example
A wheat farmer worried about falling prices sells wheat futures at $6.00/bushel. If the spot price drops to $5.20 at harvest, the short futures position offsets the revenue shortfall, locking in $6.00.
Related Terms
Forward Contract
A private, over-the-counter agreement to buy or sell an asset at a predetermined price on a specified future date.
IntermediateFutures Contract
A standardized, exchange-traded agreement to buy or sell an asset at a fixed price on a set future date, settled daily via mark-to-market.
BeginnerOptions Contract
A contract giving the buyer the right — but not the obligation — to buy or sell an underlying asset at a set price before or on expiration.
Beginner