Derivative instruments definition

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What are Derivative Instruments?

A derivative is a financial instrument that has the following characteristics:

  • It is a financial instrument or a contract that requires either a small or no initial investment;

  • There is at least one notional amount (the face value of a financial instrument, which is used to make calculations based on that amount) or payment provision;

  • It can be settled net, which is a payment that reflects the net difference between the ending positions of the two parties; and

  • Its value changes in relation to a change in an underlying, which is a variable, such as an interest rate , exchange rate , credit rating , or commodity price, that is used to determine the settlement of a derivative instrument. The value of a derivative can even change in conjunction with the weather.

A financial instrument is a document that has monetary value or which establishes an obligation to pay. Examples of financial instruments are cash , foreign currencies , accounts receivable , loans , bonds , equity securities , and accounts payable .

Characteristics of Derivative Instruments

The key characteristics of derivative instruments are as follows:

  • Underlying asset dependence . The value of a derivative is linked to an underlying asset, such as stocks, bonds, commodities, currencies, interest rates, or market indices.

  • Leverage . Derivatives allow investors to control large positions with a relatively small investment (margin), increasing potential gains but also magnifying losses.

  • High risk and volatility . Due to leverage and market fluctuations, derivatives can be highly volatile and pose significant financial risks.

  • Contractual arrangement . Derivatives are binding agreements between two or more parties, specifying future transactions at predetermined prices.

  • No ownership of the underlying asset . Unlike direct investment, holding a derivative does not mean owning the underlying asset (e.g., a stock option does not mean owning the stock).

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How Derivative Instruments are Used

In essence, a derivative constitutes a bet that something will increase or decrease. As such, a derivative can be used in two ways. Either it is a tool for avoiding risk , or it is used to speculate. In the former case, derivatives are used to offset expected changes in the value of an asset or liability , so that the net effect is zero. In the latter case, an entity accepts risk in order to possibly earn above-average profits. Speculation using derivatives can be extremely risky, since a large adverse movement in an underlying could trigger a massive liability for the holder of a derivative.

Examples of Derivative Instruments

Examples of derivatives include the following:

  • Call option . An agreement that gives the holder the right, but not the obligation, to buy shares, bonds, commodities, or other assets at a predetermined price within a predefined time period.

  • Put option . An agreement that gives the holder the right, but not the obligation, to sell shares, bonds, commodities, or other assets at a predetermined price within a predefined time period.

  • Forward . An agreement to buy or sell an asset at a predetermined price as of a future date. This is a highly customizable derivative, which is not traded on an exchange.

  • Futures . An agreement to buy or sell an asset at a predetermined price as of a future date. This is a standardized agreement, so that they can be more easily traded on a futures exchange.

  • Swap . An agreement to exchange one security for another, with the intent of altering the security terms to which each party individually is subjected.