A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc.
Putting it in a simple word - A derivative is a contract between two parties which derives its value/price from an underlying asset. It is a financial instrument which derives its value/price from the underlying assets.
Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps. Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives constitute a greater proportion of the derivatives market.
Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With the differing values of national currencies, international traders needed a system to account for differences. Today, derivatives are based upon 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.
For example, imagine a European investor, whose investment accounts are all denominated in euros (EUR). This investor purchases shares of a U.S. company through a U.S. exchange using U.S. dollars (USD). Now the investor is exposed to exchange-rate risk while holding that stock. Exchange-rate risk the threat that the value of the euro will increase in relation to the USD. If the value of the euro rises, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros.
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.
A speculator who expects the euro to appreciate compared to 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.
By Suren Subramaniam | 30 September 2020