The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. A derivative is set between two or more parties that can trade on an exchange or over-the-counter (OTC).

These contracts can be used to trade any number of assets and carry their own risks. Prices for derivatives derive from fluctuations in the underlying asset. These financial securities are commonly used to access certain markets and may be traded to hedge against risk. Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation). Derivatives can move risk (and the accompanying rewards) from the risk-averse to the risk seekers.

• Derivatives are financial contracts, set between two or more parties, that derive their value from an underlying asset, group of assets, or benchmark.

• A derivative can trade on an exchange or over-the-counter.

• Prices for derivatives derive from fluctuations in the underlying asset.

• Derivatives are usually leveraged instruments, which increases their potential risks and rewards.

• Common derivatives include futures contracts, forwards, options, and swaps.

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A derivative is a complex type of financial security that is set between two or more parties. Traders use derivatives to access specific markets and trade different assets. Typically, derivatives are considered a form of advanced investing. The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. Contract values depend on changes in the prices of the underlying asset.

Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. These assets are commonly traded on exchanges or OTC and are purchased through brokerages. The Chicago Mercantile Exchange (CME) is among the world's largest derivatives exchanges.1

It's important to remember that when companies hedge, they're not speculating on the price of the commodity. Instead, the hedge is merely a way for each party to manage risk. Each party has its profit or margin built into the price, and the hedge helps to protect those profits from being eliminated by market moves in the price of the commodity.

OTC-traded derivatives generally have a greater possibility of counterparty risk, which is the danger that one of the parties involved in the transaction might default. These contracts trade between two private parties and are unregulated. To hedge this risk, the investor could purchase a currency derivative to lock in a specific exchange rate. Derivatives that could be used to hedge this kind of risk include currency futures and currency swaps.

Exchange-traded derivatives are standardized and more heavily regulated than those that are traded over-the-counter.

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SELECT A STOCK

TSLA

TESLA INC

AAPL

APPLE INC

NKE

NIKE INC

AMZN

AMAZON.COM, INC

WMT

WALMART INC

SELECT INVESTMENT AMOUNT

$

SELECT A PURCHASE DATE

              2 years ago                      5 years ago                      10 years ago         

CALCULATE

Derivatives were originally used to ensure balanced exchange rates for internationally traded goods. International traders needed a system to account for the differing values of national currencies.

Assume a European investor has investment accounts that are all denominated in euros (EUR). Let's say they purchase shares of a U.S. company through a U.S. exchange using U.S. dollars (USD). This means they are now exposed to exchange rate risk while holding that stock. Exchange rate risk is the threat that the value of the euro will increase in relation to the USD. If this happens, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros.

A speculator who expects the euro to appreciate versus the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have a holding or portfolio presence in the underlying asset.

Many derivative instruments are leveraged, which means a small amount of capital is required to have an interest in a large amount of value in the underlying asset.

Derivatives today are based on a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.

There are many different types of derivatives that can be used for risk management, speculation, and leveraging a position. The derivatives market is one that continues to grow, offering products to fit nearly any need or risk tolerance.

There are two classes of derivative products: "lock" and "option." Lock products (e.g., futures, forwards, or swaps) bind the respective parties from the outset to the agreed-upon terms over the life of the contract. Option products (e.g., stock options), on the other hand, offer the holder the right, but not the obligation, to buy or sell the underlying asset or security at a specific price on or before the option's expiration date. The most common derivative types are futures, forwards, swaps, and options.

A futures contract, or simply futures, is an agreement between two parties for the purchase and delivery of an asset at an agreed-upon price at a future date. Futures are standardized contracts that trade on an exchange. Traders use a futures contract to hedge their risk or speculate on the price of an underlying asset. The parties involved are obligated to fulfill a commitment to buy or sell the underlying asset.