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Definition: Derivative

A Derivative is a financial instrument or a security whose value depends on or is 'derived' from the value of an underlying asset. Movement in the price of underlying asset changes the price of dependent Derivative too.

These underlying assets may be stocks, bonds, currencies, commodities, interest rate and market indexes.

Derivatives are of four types:-

  • Futures-A contract between two parties, where payment takes place at a specific date in the future at a price determined today. These are non-standardized legal contracts privately drafted by two parties.
  • Forwards-These are contracts to buy or sell an asset on or before a future date at a price determined today. These are standardized contracts, the terms of which are defined by the exchange on which they are dealt.
  • Options-Options are contracts that give the owner (option holder) the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The other party i.e. the option writer has to respect the decision of the option holder and gets a premium for giving the option holder this choice.
  • Swaps-Swaps are contracts to exchange cash flows on or before a specified future date based on the underlying value of assets like currencies exchange rates, interest rates, commodities exchange, stocks or other assets.

Derivatives are dealt with in two ways:-

  • OTC (Over The Counter) -Over-the-counter (OTC) derivatives are contracts that are traded and negotiated directly between two parties, without going through an exchange or other intermediary. OTC transactions are private transactions. Usually, swaps, options and forward rate agreements are traded this way.
  • Exchange traded-These are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. The terms of such contracts are usually defined by the exchange.

Hence, this concludes the definition of Derivative along with its overview.

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