Derivative

[stockbroker]

A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties. The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.


Under U.S. law and the laws of most developed countries, derivatives have special legal exemptions which make them a particularly attractive legal form through which to extend credit. However, the strong creditor protections afforded to derivatives counterparties--in combination with their complexity and lack of transparency--can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to mask credit risk from third parties while protecting derivative counterparties contributed to both the financial crisis of 2008 in the United States and the European sovereign debt crises in Greece and Italy. Financial reforms within the U.S. since the financial crisis have only served to reinforce special protections for derivatives--including greater access to government guarantees--while minimizing disclosure to broader financial markets.

[stockbroker]

One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (e.g., forward, option, swap); the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile.


Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies.


Third parties can use publicly available derivatives prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.

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