What Does Derivative Mean?

A security whose price is dependent upon or derived from one or more underlying assets. The
derivative itself is merely a contract between two or more parties. Its value is determined by
fluctuations in the underlying asset. The most common underlying assets include stocks,
bonds, commodities, currencies, interest rates and market indexes. Most derivatives are
characterized by high leverage.

Investopedia explains Derivative

Futures contracts, forward contracts, options and swaps are the most common types of
derivatives. Derivatives are contracts and can be used as an underlying asset. There are even
derivatives based on weather data, such as the amount of rain or the number of sunny days in a
particular region.

Derivatives are generally used as an instrument to hedge risk, but can also be used
for speculative purposes. For example, a European investor purchasing shares of an American
company off of an American exchange (using U.S. dollars to do so) would be exposed to
exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase
currency futures to lock in a specified exchange rate for the future stock sale and currency
conversion back into Euros.

A derivative is anything that is valued based upon some other asset. In other words, it
derives its value from something else.

The long answer: A call option, which is a simple type of stock option that gives the
buyer the right (but not the obligation) to buy 100 shares of a certain stock at a pre-
determined price, is a derivative because the value of the option depends on what the
underlying stock does. In the case of GE stock options, for instance, whether the stock
option makes money, loses money, or breaks even depends entirely upon what General
Electric shares do. Thus, the options “derive” their value from GE stock. They are a
derivative.
Farmers in the heartland are responsible for a lot of derivatives in the United States.
They often want to lock in a price for their crops in order to protect their harvest and
calculate the profits they’ll make each season. They work with special brokers or
companies to sell futures contracts on commodities exchanges. These contracts allow
them to sell crops they haven’t yet grown or which are not yet ready for harvest at a
predetermined price. The value of these contracts (what the farmer gets paid) depends
on what the underlying commodity does over the period of the futures contract. Again,
whether a futures contract makes money, loses money, or breaks even depends entirely
on the price of the commodity to which it is tied. A coffee futures contract, for instance,
“derives” its value from the price of coffee beans.

The Different Types of Derivatives

Derivatives are used banks to protect themselves from interest rates changes. As we
already discussed, farmers use them extensively (even if they don’t realize it because
they are working with a big company such as Cargill). Employees in startups that are
paid with stock options own derivatives. Some insurance contracts are structured as
derivatives to protect lenders in case their loans go bad. Energy companies use futures
to lock in oil prices when they think they are high to protect the company. Airlines use
futures to lock in oil when it's low, such as Southwest Airlines did, allowing it to pay $10
per barrel long after the cost of oil had risen to $100+ per barrel. There are even
weather derivatives to protect certain types of businesses from hurricanes.

Why Are Derivatives Dangerous

Although derivatives can help make the economy function by reducing risk for farmers,
oil companies, startup employees, and more, left unchecked, they can introduce
“systematic risk”. Only a handful of firms represent a massive portion of the total
derivatives traded in the world meaning that if one of them went bankrupt, it could lead
to a daisy-chain effect that caused all of the others to fail, wiping out the entire financial
system.
The failure of Lehman Brothers nearly caused this to happen during the Credit Crisis and
would have succeeded had it not been for the extraordinary intervention by the Federal
Reserve, Treasury, FDIC, and other government agencies.

In finance, a derivative is a financial instrument (or, more simply, an agreement between two
parties) that has a value, based on the expected future price movements of the asset to which it
is linked—called the underlying—[1] such as a share or a currency. There are many kinds of
derivatives, with the most common being swaps, futures, and options. Derivatives are a form
of alternative investment.

A derivative is not a stand-alone asset, since it has no value of its own. However, more common
types of derivatives have been traded on markets before their expiration date as if they were
assets. Among the oldest of these are rice futures, which have been traded on the Dojima Rice
Exchange since the eighteenth century.[2]

Derivatives are usually broadly categorized by:

 the relationship between the underlying and the derivative (e.g., forward, option, swap);
 the type of underlying (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);
 their pay-off profile.

Another arbitrary distinction is between:[3]

 vanilla derivatives (simple and more common); and

 exotic derivatives (more complicated and specialized).