Derivative

Definition

A derivative is a financial contract that derives its value from an underlying asset or group of assets such as stocks, bonds, commodities, currencies, interest rates, or market indexes. Its price is determined by fluctuations in this underlying asset. They are primarily used for hedging risk or for speculative purposes.

Phonetic

The phonetic spelling of the word “Derivative” is /dɪˈrɪvətɪv/.

Key Takeaways

Absolutely, here are three main takeaways about Derivative:“`html

Derivative represents the rate of change: The derivative of a function at a certain point represents the rate at which a quantity is changing at that point. In other words, it shows how much a function is changing per unit.
Geometric interpretation: In the geometric sense, the derivative at a specific point is the slope of the line tangent to the function at that point. This is often used in applications where it’s important to know the direction and rate of a function’s increase or decrease.
Applications of derivatives: Derivatives are widely used in various fields such as physics, engineering, economics, and more. They used to solve problems involving rates of change and motion, work on optimization problems, and to approximate complex functions.

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Importance

Derivatives are important in business and finance as they are essential risk management tools used to hedge or mitigate potential losses from price fluctuations in an asset’s value over a certain period. They allow companies and investors to bet on the future movements in the price of an asset without necessarily owning the asset. Derivatives can also be used for speculation, allowing traders to profit from the change in value of the underlying assets. As a financial contract, derivatives derive their value from an underlying asset such as stocks, bonds, commodities, currencies, interest rates and market indexes, allowing diverse trading strategies and helping to stabilize the financial system by dispersing risk. Thus, understanding derivatives play a vital role in strategic planning and decision making in finance and business.

Explanation

A derivative is a financial instrument that derives its value from an underlying asset or group of assets, such as stocks, bonds, commodities, currencies, interest rates, or market indexes. The primary purpose of a derivative is to allow parties to manage or mitigate potential risks associated with the underlying asset. For instance, it is used to insure against price movements, enhancing liquidity while reducing the risk of default for certain transactions. Derivatives can also be used for speculation, taking on risk in the hopes of making a profit.Derivatives, by providing effective risk management countermeasures, give businesses a significant means to change or adjust their risk exposure to particular financial markets. For example, if a U.S. company is doing business with a European firm and will be paid in Euros a month later, the value of Euros could decrease substantially within that period, causing a loss. So, in order to protect itself from such a risk, the U.S. firm may enter into a derivatives contract, called a forex forward, that locks the present exchange rate. Hence, derivatives act as a vital financial tool to safeguard against unforeseen price movements and to stabilize revenues and costs.

Examples

1. Futures Contracts: A common example of a derivative in the business world is the futures contract. This financial contract obligates the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. For example, a wheat farmer may use futures contracts to lock in a certain price for selling their crop at a future date, to eliminate the risk of price changes in the market.2. Options: Options are another example of a derivative. They give the holder the right, but not the obligation, to buy or sell an underlying asset, such as a stock, at a certain price before a certain date. An investor, for example, may purchase a call option (betting the stock will rise) or a put option (betting the stock will fall) on a particular stock, speculating on future price changes.3. Credit derivatives: These are financial assets like forward contracts, swaps, and options for which the price is dependent upon the credit risk of private entities or governmental entities. A real-world example of this is a credit default swap, which is a financial agreement that the seller will compensate the buyer in the event of a loan default or other credit event. The buyer of the credit default swap pays a premium in return for this potential payout. This was notably used in the lead up to the 2008 financial crisis, where these were sold as insurance against mortgage-backed securities.

Frequently Asked Questions(FAQ)

What is a derivative in finance and business?

A derivative is a financial contract between two or more parties that derives its value from an underlying asset. These underlying assets could include stocks, bonds, commodities, currencies, interest rates, or market indexes.

What are the types of derivatives?

The main types of derivatives are futures, options, forwards, and swaps. Each type of derivative has its own functionality and purpose but they all derive their value from an underlying asset.

How do companies use derivatives?

Companies often use derivatives to hedge against risks, such as fluctuations in currency exchange rates, interest rates, or commodity prices. Additionally, derivatives can be used for speculative purposes, hoping to profit from changes in the price of the underlying asset.

What is the difference between an option and a future derivative?

The primary difference is that an option gives the holder the right, but not the obligation, to buy or sell an asset at a set price on or before a certain date, while a futures contract obligates the holder to buy or sell the asset at a predetermined price at a specified future date.

Are derivatives considered risky?

Derivatives can be risky because their value is derived from another asset, making them highly susceptible to market fluctuations. However, companies can also use derivatives as a tool to manage and minimize risks.

What does the term underlying asset refer to?

An underlying asset in a derivatives contract refers to the financial asset upon which the derivative’s price is based. It could be a stock, a bond, a commodity, a currency, an interest rate, or a market index.

How are derivatives traded?

Derivatives can be traded either on an exchange or over-the-counter (OTC). Exchange-traded derivatives are standardized, regulated, and have clear, transparent pricing. Over-the-counter derivatives are privately negotiated and can be tailored to fit the specific needs of the parties involved.

What does going long and going short mean in derivatives trading?

Going long on a derivative means buying it with the expectation that the underlying asset’s price will go up. In contrast, going short means selling a derivative with the belief that the underlying asset’s price will go down.

Related Finance Terms

Options
Futures
Swaps
Forward contract
Hedge

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