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Derivative (finance)
From Wikipedia, the free encyclopedia

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Please help improve this article by adding reliable references. Unsourced material may be challenged and removed.(October 2010)

Financial markets

Public market

Exchange

Securities
Bond market

Fixed income

Corporate bond

Government bond

Municipal bond

Bond valuation

High-yield debt
Stock market

Stock
 Preferred stock

Common stock

Registered share

Voting share

Stock exchange
Derivatives market

Securitization

Hybrid security

Credit derivative

Futures exchange

OTC, non organized

Spot market

Forwards

Swaps

Options
Foreign exchange

Exchange rate

Currency

Other markets

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Reinsurance market

Commodity market

Real estate market

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Finance series

Banks and banking

Corporate finance
 Personal finance

Public finance
v·d·e

In finance, a derivative is a financial instrument whose value depends on other, more basic, underlying variables[1] Such variables

can be the price of another financial instrument (the underlying asset[2]), interest rates, volatilities, indices, etc.contract whose payoff

depends on the behavior of some benchmark, which is known as the "underlying". The most common derivatives

are futures, options, and swaps.

Among the oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[3]

Derivatives are usually 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.

Contents
[hide]

• 1 Uses

○ 1.1 Hedging

○ 1.2 Speculation and arbitrage

• 2 Types of derivatives

○ 2.1 OTC and exchange-

traded

○ 2.2 Common derivative

contract types

○ 2.3 Examples

• 3 Valuation

○ 3.1 Market and arbitrage-free

 prices

○ 3.2 Determining the market

price

○ 3.3 Determining the

arbitrage-free price

• 4 Criticism

○ 4.1 Possible large losses

○ 4.2 Counter-party risk

○ 4.3 Large notional value

○ 4.4 Leverage of an

economy's debt

• 5 Benefits

• 6 Government regulation

• 7 Definitions

• 8 See also

• 9 References

• 10 Further reading

• 11 External links

Uses

This section does not cite any references or sources.

Please help improve this section by adding citations to reliable sources.
Unsourced material may be challenged and removed. (March 2011)

Derivatives are used by investors to:

 provide leverage (or gearing), such that a small movement in the underlying value can cause a large
difference in the value of the derivative;

 speculate and make a profit if the value of the underlying asset moves the way they expect (e.g.,
moves in a given direction, stays in or out of a specified range, reaches a certain level);
 hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in
the opposite direction to their underlying position and cancels part or all of it out;

 obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather
derivatives);

 create option ability where the value of the derivative is linked to a specific condition or event (e.g.,
the underlying reaching a specific price level).

[edit]Hedging

This section does not cite any references or sources.

Please help improve this section by adding citations to reliable sources. Unsourced material may
be challenged andremoved. (October 2010)

Derivatives allow risk related to the price of the underlying asset to be transferred from one party to
another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified
amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for
the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there
is still the risk that no wheat will be available because of events unspecified by the contract, such as the
weather, or that one party will renege on the contract. Although a third party, called a clearing house,
insures a futures contract, not all derivatives are insured against counter-party risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign
the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in
the contract and acquires the risk that the price of wheat will rise above the price specified in the contract
(thereby losing additional income that he could have earned). The miller, on the other hand, acquires the
risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the
future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price
specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the
counter-party is the insurer (risk taker) for another type of risk.

Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that
has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The
individual or institution has access to the asset for a specified amount of time, and can then sell it in the
future at a specified price according to the futures contract. Of course, this allows the individual or
institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate
unexpectedly from the market's current assessment of the future value of the asset.
Derivatives traders at the Chicago Board of Trade.

Derivatives can serve legitimate business purposes. For example, a corporation borrows a large sum of
money at a specific interest rate.[4] The rate of interest on the loan resets every six months. The
corporation is concerned that the rate of interest may be much higher in six months. The corporation
could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months
after purchases on a notional amount of money.[5] If the interest rate after six months is above the contract
rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation
will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning
the rate increase and stabilize earnings.
[edit]Speculation and arbitrage
Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some
individuals and institutions will enter into a derivative contract to speculate on the value of the underlying
asset, betting that the party seeking insurance will be wrong about the future value of the underlying
asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when
the future market price is high, or to sell an asset in the future at a high price according to a derivative
contract when the future market price is low.

Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of
an asset falls below the price specified in a futures contract to sell the asset.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader
at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of
poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like
the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[6]

[edit]Types of derivatives
[edit]OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are
traded in the market:

 Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. Products such
as swaps, forward rate agreements, and exotic options are almost always traded in this way. The
OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to
disclosure of information between the parties, since the OTC market is made up of banks and other
highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because
trades can occur in private, without activity being visible on any exchange. According to the Bank for
International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008).
[7]
Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS),
9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12%
are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party.
Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party
relies on the other to perform.

 Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via
specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where
individuals trade standardized contracts that have been defined by the exchange.[8] A derivatives
exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides
of the trade to act as a guarantee. The world's largest[9] derivatives exchanges (by number of
transactions) are the Korea Exchange (which listsKOSPI Index Futures & Options), Eurex (which lists
a wide range of European products such as interest rate & index products), and CME Group (made
up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the
2008 acquisition of theNew York Mercantile Exchange). According to BIS, the combined turnover in
the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative
instruments also may trade on traditional exchanges. For instance, hybrid instruments such as
convertible bonds and/or convertible preferred may be listed on stock or bond exchanges.
Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and
various other instruments that essentially consist of a complex set of options bundled into a simple
package are routinely listed on equity exchanges. Like other derivatives, these publicly traded
derivatives provide investors access to risk/reward and volatility characteristics that, while related to
an underlying commodity, nonetheless are distinctive.
[edit]Common derivative contract types

There are three major classes of derivatives:

 1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price
specified today. A futures contract differs from a forward contract in that the futures contract is a
standardized contract written by a clearing house that operates an exchange where the contract
can be bought and sold, whereas a forward contract is a non-standardized contract written by the
parties themselves.

2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of
a call option) or sell (in the case of aput option) an asset. The price at which the sale takes place
is known as the strike price, and is specified at the time the parties enter into the option. The
option contract also specifies a maturity date. In the case of a European option, the owner has
the right to require the sale to take place on (but not before) the maturity date; in the case of
an American option, the owner can require the sale to take place at any time up to the maturity
date. If the owner of the contract exercises this right, the counter-party has the obligation to carry
out the transaction.

3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the
underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or
other assets.

More complex derivatives can be created by combining the elements of these basic types. For example,
the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified
future date.
[edit]Examples

The overall derivatives market has five major classes of underlying asset:

 interest rate derivatives (the largest)

 foreign exchange derivatives

 credit derivatives

 equity derivatives

 commodity derivatives

Some common examples of these derivatives are:

UNDERLYI CONTRACT TYPES

 Exchange-
Exchange-
NG traded OTC swap OTC forward OTC option
traded options
futures

Option
DJIA Index
on DJIA Index Back-to-back Stock option
future
Equity future Equity swap Repurchase Warrant
Single-stock
Single-share agreement Turbo warrant
future
option

Interest rate
Option on
Eurodollar cap and floor
Interest Eurodollar future Interest rate Forward rate
future Swaption
rate Option on swap agreement
Euribor future Basis swap
Euribor future
Bond option

Credit
Option on Bond default swap Repurchase Credit default
Credit Bond future
future Total return agreement option
swap

Foreign Currency Option on Currency Currency Currency

exchange future currency future swap forward option

Iron ore
WTI crude oil Weather Commodity
Commodity forward Gold option
futures derivatives swap
contract

Other examples of underlying exchangeables are:

 Property (mortgage) derivatives

 Economic derivatives that pay off according to economic reports[10] as measured and reported by
national statistical agencies

 Freight derivatives

 Inflation derivatives

 Weather derivatives

 Insurance derivatives[citation needed]

 Emissions derivatives[11]
[edit]Valuation

Total world derivatives from 1998–2007[12] compared to total world wealth in the year 2000[13]

[edit]Market and arbitrage-free prices

Two common measures of value are:

 Market price, i.e., the price at which traders are willing to buy or sell the contract;

 Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts;
see rational pricing.
[edit]Determining the market price
For exchange-traded derivatives, market price is usually transparent (often published in real time by the
exchange, based on all the current bids and offers placed on that particular contract at antrading is
handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts,
there is no central exchange to collate and disseminate prices.
[edit]Determining the arbitrage-free price
The arbitrage-free price for a derivatives contract can be complex, and there are many different variables
to consider. Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the
arbitrage fee price is relatively straightforward, involving the price of the underlying together with the cost
of carry (income received less interest costs), although there can be complexities.
However, for options and more complex derivatives, pricing involves developing a complex pricing model:
understanding the stochastic process of the price of the underlying asset is often crucial. A key equation
for the theoretical valuation of options is the Black–Scholes formula, which is based on the assumption
that the cash flows from a European stock option can be replicated by a continuous buying and selling
strategy using only the stock. A simplified version of this valuation technique is the binomial options
model.

OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not
publicly traded, no market price is available to validate the theoretical valuation. And most of the model's
results are input-dependant (meaning the final price depends heavily on how we derive the pricing
inputs).[14] Therefore it is common that OTC derivatives are priced by Independent Agents that both
counterparties involved in the deal designate upfront (when signing the contract).

[edit]Criticism

Derivatives are often subject to the following criticisms:

[edit]Possible large losses
See also: List of trading losses

The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives
allow investors to earn large returns from small movements in the underlying asset's price. However,
investors could lose large amounts if the price of the underlying moves against them significantly. There
have been several instances of massive losses in derivative markets, such as:

 American International Group (AIG) lost more than US$18 billion through a subsidiary over
the preceding three quarters on Credit Default Swaps (CDS).[15] The US federal government
then gave the company US$85 billion in an attempt to stabilize the economy before an
imminent stock market crash. It was reported that the gifting of money was necessary
because over the next few quarters, the company was likely to lose more money.

 The loss of US$7.2 Billion by Société Générale in January 2008 through mis-use of futures
contracts.

 The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in
September 2006 when the price plummeted.

 The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.

 The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft
AG.[16]

 The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[17]
[edit]Counter-party risk
Some derivatives (especially swaps) expose investors to counter-party risk.

For example, suppose a person wanting a fixed interest rate loan for his business, but finding that
banks only offer variable rates, swaps payments with another business who wants a variable rate,
synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it
can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable
rate again. If interest rates have increased, it is possible that the first business may be adversely
affected, because it may not be prepared to pay the higher variable rate.

Different types of derivatives have different levels of counter-party risk. For example, standardized
stock options by law require the party at risk to have a certain amount deposited with the exchange,
showing that they can pay for any losses; banks that help businesses swap variable for fixed rates
on loans may do credit checks on both parties. However, in private agreements between two
companies, for example, there may not be benchmarks for performing due diligence and risk
analysis.
[edit]Large notional value
Derivatives typically have a large notional value. As such, there is the danger that their use could
result in losses that the investor would be unable to compensate for. The possibility that this could
lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed
investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial
weapons of mass destruction.' The problem with derivatives is that they control an increasingly
larger notional amount of assets and this may lead to distortions in the real capital and equities
markets. Investors begin to look at the derivatives markets to make a decision to buy or sell
securities and so what was originally meant to be a market to transfer risk now becomes a leading
indicator. (See Berkshire Hathaway Annual Report for 2002)
[edit]Leverage of an economy's debt
Derivatives massively leverage the debt in an economy, making it ever more difficult for the
underlying real economy to service its debt obligations, thereby curtailing real economic activity,
which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S.Federal
Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the
primary causes of the 1920s–30sGreat Depression. (See Berkshire Hathaway Annual Report for
2002)

[edit]Benefits

The use of derivatives also has its benefits:

 Derivatives facilitate the buying and selling of risk, and many people[who?] consider this to have a
positive impact on the economic system. Although someone loses money while someone else
gains money with a derivative, under normal circumstances, trading in derivatives should not
adversely affect the economic system because it is not zero sum in utility.

 Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed
that the use of derivatives has softened the impact of the economic downturn at the beginning of
the 21st century.[citation needed]
[edit]Government regulation
In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary
Gensler, the chairman of the Commodity Futures Trading Commission which regulates most
derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to
higher costs to all Americans." More oversight of the banks in this market is needed, he also said.
Additionally, the report said, "[t]heDepartment of Justice is looking into derivatives, too. The
department’s antitrust unit is actively investigating 'the possibility of anticompetitive practices in the
credit derivatives clearing, trading and information services industries,' according to a department
spokeswoman."[18]

[edit]Definitions

 Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that
creates a single legal obligation covering all included individual contracts. This means that a
bank’s obligation, in the event of the default or insolvency of one of the parties, would be the net
sum of all positive and negative fair values of contracts included in the bilateral netting
arrangement.

 Credit derivative: A contract that transfers credit risk from a protection buyer to a credit
protection seller. Credit derivative products can take many forms, such as credit default swaps,
credit linked notes and total return swaps.

 Derivative: A financial contract whose value is derived from the performance of assets, interest
rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of
financial contracts including structured debt obligations and deposits, swaps, futures, options,
caps, floors, collars, forwards and various combinations thereof.

 Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures

contracts and options) that are transacted on an organized futures exchange.

 Gross negative fair value: The sum of the fair values of contracts where the bank owes money
to its counter-parties, without taking into account netting. This represents the maximum losses
 the bank’s counter-parties would incur if the bank defaults and there is no netting of contracts,
and no bank collateral was held by the counter-parties.

 Gross positive fair value: The sum total of the fair values of contracts where the bank is owed
money by its counter-parties, without taking into account netting. This represents the maximum
losses a bank could incur if all its counter-parties default and there is no netting of contracts,
and the bank holds no counter-party collateral.

 High-risk mortgage securities: Securities where the price or expected average life is highly
sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk
mortgage securities.

 Notional amount: The nominal or face amount that is used to calculate payments made on
swaps and other risk management products. This amount generally does not change hands and
is thus referred to as notional.

 Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are
transacted off organized futures exchanges.

 Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics

depend on one or more indices and / or have embedded forwards or options.

 Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common
shareholders equity, perpetual preferred shareholders equity with non-cumulative
dividends, retained earnings, and minority interests in the equity accounts of consolidated
subsidiaries. Tier 2 capital consists of subordinated debt, intermediate-term preferred stock,
cumulative and long-term preferred stock, and a portion of a bank’s allowance for loan and
lease losses.
[edit]See also

Book: Finance

Wikipedia Books are collections of

articles that can be downloaded or

ordered in print.

 Dual currency deposit

 Forward contract

 FX Option
[edit]References
1. ^ John C. Hull, Options, Futures and Other Derivatives, Sixth Edition, Prentice Hall 2006, page 1

2. ^ McDonald, R.L. (2006) Derivatives markets. Boston: Addison-Wesley

3. ^ Kaori Suzuki and David Turner (December 10, 2005). "Sensitive politics over Japan's staple crop
delays rice futures plan". The Financial Times. Retrieved October 23, 2010.

4. ^ Chisolm, Derivatives Demystified (Wiley 2004)

5. ^ Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal.

6. ^ News.BBC.co.uk, "How Leeson broke the bank – BBC Economy"

7. ^ BIS survey: The Bank for International Settlements (BIS) semi-annual OTC derivatives
statistics report, for end of June 2008, shows US$683.7 billion total notional amounts outstanding of

OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular OTC

Derivatives Market Statistics.

8. ^ Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ :
Pearson/Prentice Hall, c2009

9. ^ Futures and Options Week: According to figures published in F&O Week 10 October 2005. See
also FOW Website.

10. ^ "Biz.Yahoo.com". Biz.Yahoo.com. 2010-08-23. Retrieved 2010-08-29.

11. ^ FOW.com, Emissions derivatives, 1 December 2005

12. ^ "Bis.org". Bis.org. 2010-05-07. Retrieved 2010-08-29.

13. ^ "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006".
Retrieved 9 June 2009.

14. ^ Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review, 10-30-
2009. http://www.hedgefundsreview.com/hedge-funds-review/news/1560286/otc-pricing-deal-struck-

fitch-solutions-pricing-partners

15. ^ Kelleher, James B. (2008-09-18). ""Buffett's Time Bomb Goes Off on Wall Street" by James B.
Kelleher of Reuters". Reuters.com. Retrieved 2010-08-29.

16. ^ Edwards, Franklin (1995), "Derivatives Can Be Hazardous To Your Health: The Case of
Metallgesellschaft", Derivatives Quarterly (Spring 1995): 8–17

17. ^ Whaley, Robert (2006). Derivatives: markets, valuation, and risk management. John Wiley and
Sons. p. 506. ISBN 0471786322.

18. ^ Story, Louise, "A Secretive Banking Elite Rules Trading in Derivatives", The New York Times,
December 11, 2010 (December 12, 2010 p. A1 NY ed.). Retrieved 2010-12-12.
 [edit]Further reading
 Mehraj Mattoo (1997), Structured Derivatives: New Tools for Investment Management A
Handbook of Structuring, Pricing & Investor Applications (Financial Times) Amazon listing
[edit]External links
 BBC News – Derivatives simple guide

 European Union proposals on derivatives regulation – 2008 onwards

 Derivatives in Africa

 Derivatives Litigation
Catego

Derivative
From Wikipedia, the free encyclopedia

This article is an overview of the term as used in calculus. For a less technical overview of the subject,
see Differential calculus. For other uses, see Derivative (disambiguation).

The graph of a function, drawn in black, and a tangent line to that function, drawn in red. The slope of the tangent line is
equal to the derivative of the function at the marked point.

Topics in Calculus

Fundamental theorem

Limits of functions

Continuity
 Mean value theorem

[show]Differential
calculus

[show]Integral calculus

[show]Vector calculus

[show]Multivariable
calculus

In calculus, a branch of mathematics, the derivative is a measure of how a function changes as its input
changes. Loosely speaking, a derivative can be thought of as how much one quantity is changing in response
to changes in some other quantity; for example, the derivative of the position of a moving object with respect to
time is the object's instantaneous velocity (conversely, integrating a car's velocity over time yields the distance
traveled).

The derivative of a function at a chosen input value describes the best linear approximation of the function near
that input value. For a real-valued function of a single real variable, the derivative at a point equals the slope of
the tangent line to the graph of the function at that point. In higher dimensions, the derivative of a function at a
point is a linear transformation called the linearization.[1] A closely related notion is the differential of a function.

The process of finding a derivative is called differentiation. The reverse process is calledantidifferentiation.
The fundamental theorem of calculus states that antidifferentiation is the same as integration. Differentiation
and integration constitute the two fundamental operations in single-variable calculus.

Contents
[hide]

• 1 Differentiation and the derivative

○ 1.1 Definition via difference quotients

○ 1.2 Example

○ 1.3 Continuity and differentiability

○ 1.4 The derivative as a function

 ○ 1.5 Higher derivatives

○ 1.6 Inflection point

• 2 Notations for differentiation

○ 2.1 Leibniz's notation

○ 2.2 Lagrange's notation

○ 2.3 Newton's notation

○ 2.4 Euler's notation

• 3 Computing the derivative

○ 3.1 Derivatives of elementary functions

○ 3.2 Rules for finding the derivative

○ 3.3 Example computation

• 4 Derivatives in higher dimensions

○ 4.1 Derivatives of vector valued functions

○ 4.2 Partial derivatives

○ 4.3 Directional derivatives

○ 4.4 The total derivative, the total

differential and the Jacobian

• 5 Generalizations

• 6 See also

• 7 Notes

• 8 References

○ 8.1 Print

○ 8.2 Online books

○ 8.3 Web pages

Differentiation and the derivative

(Click for larger image) At each point, the derivative of is the slope of a line that is tangent to the curve.
The line is always tangent to the blue curve; its slope is the derivative. Note derivative is positive where
green,negative where red, and zero where black.

Differentiation is a method to compute the rate at which a dependent output y changes with respect to the
change in the independent input x. This rate of change is called the derivative ofy with respect to x. In more
precise language, the dependence of yupon x means that y is a function of x. This functional relationship is
often denoted y = ƒ(x), where ƒ denotes the function. If x and yare real numbers, and if the graph of y is plotted
against x, the derivative measures the slope of this graph at each point.

The simplest case is when y is a linear function of x, meaning that the graph of y against x is a straight line. In
this case, y = ƒ(x) = mx + b, for real numbers m and b, and the slope m is given by

where the symbol Δ (the uppercase form of the Greek letter Delta) is an abbreviation for "change in." This
formula is true because
y + Δy = ƒ(x+ Δx) = m (x + Δx) + b = m x + b + m Δx = y + mΔx.

It follows that Δy = m Δx.

This gives an exact value for the slope of a straight line. If the function ƒ is not linear (i.e. its graph is
not a straight line), however, then the change in y divided by the change in x varies: differentiation is
a method to find an exact value for this rate of change at any given value of x.

Rate of change as a limiting value

Figure 1. The tangent line at (x, ƒ(x))

Figure 2. The secant to curve y= ƒ(x) determined by points (x, ƒ(x)) and (x+h, ƒ(x+h))
Figure 3. The tangent line as limit of secants

The idea, illustrated by Figures 1-3, is to compute the rate of change as the limiting value of
the ratio of the differences Δy / Δx as Δx becomes infinitely small.

In Leibniz's notation, such an infinitesimal change in x is denoted by dx, and the derivative ofy with
respect to x is written

suggesting the ratio of two infinitesimal quantities. (The above expression is read as "the
derivative of y with respect to x", "d y by d x", or "d y over d x". The oral form "d y d x" is often
used conversationally, although it may lead to confusion.)

The most common approach[2] to turn this intuitive idea into a precise definition uses limits, but
there are other methods, such as non-standard analysis.[3]

Definition via difference quotients

Let ƒ be a real valued function. In classical geometry, the tangent line to the graph of the
function ƒ at a real number a was the unique line through the point (a, ƒ(a)) that did not meet
the graph of ƒ transversally, meaning that the line did not pass straight through the graph. The
derivative of y with respect to x at a is, geometrically, the slope of the tangent line to the graph
of ƒ at a. The slope of the tangent line is very close to the slope of the line through (a,ƒ(a))
and a nearby point on the graph, for example (a + h, ƒ(a + h)). These lines are calledsecant
lines. A value of h close to zero gives a good approximation to the slope of the tangent line,
and smaller values (in absolute value) of h will, in general, give betterapproximations. The
slope m of the secant line is the difference between the y values of these points divided by the
difference between the x values, that is,

This expression is Newton's difference quotient. The derivative is the value of the
difference quotient as the secant lines approach the tangent line. Formally,
the derivative of the function ƒ at a is the limit
of the difference quotient as h approaches zero, if this limit exists. If the limit
exists, then ƒis differentiable at a. Here ƒ′ (a) is one of several common notations
for the derivative (see below).

Equivalently, the derivative satisfies the property that

which has the intuitive interpretation (see Figure 1) that the tangent line
to ƒ at a gives the best linear approximation

to ƒ near a (i.e., for small h). This interpretation is the easiest to

generalize to other settings (see below).

Substituting 0 for h in the difference quotient causes division by zero,

so the slope of the tangent line cannot be found directly using this
method. Instead, define Q(h) to be the difference quotient as a function
of h:

Q(h) is the slope of the secant line between (a, ƒ(a)) and
(a + h, ƒ(a + h)). If ƒ is a continuous function, meaning that its
graph is an unbroken curve with no gaps, then Q is a continuous

function away from the point h = 0. If the limit

exists, meaning that there is a way of choosing a value for Q(0)
that makes the graph of Q a continuous function, then the
function ƒ is differentiable at the point a, and its derivative
at a equals Q(0).

In practice, the existence of a continuous extension of the

difference quotient Q(h) to h = 0 is shown by modifying the
numerator to cancel hin the denominator. This process can be
long and tedious for complicated functions, and many shortcuts
are commonly used to simplify the process.
Example
The squaring function ƒ(x) = x² is differentiable at x = 3, and its
derivative there is 6. This result is established by calculating the
limit as happroaches zero of the difference quotient of ƒ(3):

Then we calculate the limit by letting h go to zero:

The last expression shows that the difference quotient

equals 6 + h when h ≠ 0 and is undefined when h = 0,
because of the definition of the difference quotient.
However, the definition of the limit says the difference
quotient does not need to be defined when h = 0.
Hence the slope of the graph of the squaring function
at the point (3, 9) is 6, and so its derivative at x = 3
is ƒ '(3) = 6.

More generally, a similar computation shows that the

derivative of the squaring function at x = a is ƒ '(a) =
2a.

Continuity and differentiability

This function does not have a derivative at the marked point,

as the function is not continuous there.
If y = ƒ(x) is differentiable at a, then ƒ must also
be continuous at a. As an example, choose a
point a and let ƒ be the step function that returns a
value, say 1, for all x less than a, and returns a
different value, say 10, for all x greater than or equal
to a. ƒ cannot have a derivative at a. If h is negative,
then a + h is on the low part of the step, so the secant
line from a to a + h is very steep, and as h tends to
zero the slope tends to infinity. If h is positive,
then a + h is on the high part of the step, so the
secant line from a to a + h has slope zero.
Consequently the secant lines do not approach any
single slope, so the limit of the difference quotient
does not exist.[4]

The absolute value function is continuous, but fails to be

differentiable atx = 0 since the tangent slopes do not
approach the same value from the left as they do from the
right.

However, even if a function is continuous at a point, it

may not be differentiable there. For example,
the absolute value function y = |x| is continuous at x =
0, but it is not differentiable there. If h is positive, then
the slope of the secant line from 0 to h is one,
whereas if h is negative, then the slope of the secant
line from 0 to h is negative one. This can be seen
graphically as a "kink" or a "cusp" in the graph at x =
0. Even a function with a smooth graph is not
differentiable at a point where its tangent is vertical:
For instance, the function y = 3√x is not differentiable
at x = 0.

In summary: for a function ƒ to have a derivative it

is necessary for the function ƒ to be continuous, but
continuity alone is not sufficient.

Most functions that occur in practice have derivatives

at all points or at almost every point. Early in the
history of calculus, many mathematicians assumed
that a continuous function was differentiable at most
points. Under mild conditions, for example if the
function is a monotone function or a Lipschitz
function, this is true. However, in 1872 Weierstrass
found the first example of a function that is continuous
everywhere but differentiable nowhere. This example
is now known as the Weierstrass function. In
1931, Stefan Banach proved that the set of functions
that have a derivative at some point is a meager set in
the space of all continuous functions.[5] Informally, this
means that hardly any continuous functions have a
derivative at even one point.

The derivative as a function

Let ƒ be a function that has a derivative at every
point a in the domain of ƒ. Because every point ahas
a derivative, there is a function that sends the
point a to the derivative of ƒ at a. This function is
written f′(x) and is called the derivative function or
the derivative of ƒ. The derivative of ƒ collects all the
derivatives of ƒ at all the points in the domain of ƒ.

Sometimes ƒ has a derivative at most, but not all,

points of its domain. The function whose value
at a equals f′(a) whenever f′(a) is defined and
elsewhere is undefined is also called the derivative
of ƒ. It is still a function, but its domain is strictly
smaller than the domain of ƒ.

Using this idea, differentiation becomes a function of

functions: The derivative is an operator whose domain
is the set of all functions that have derivatives at every
point of their domain and whose range is a set of
functions. If we denote this operator by D, then D(ƒ) is
the function f′(x). Since D(ƒ) is a function, it can be
evaluated at a point a. By the definition of the
derivative function, D(ƒ)(a) = f′(a).

For comparison, consider the doubling

function ƒ(x) =2x; ƒ is a real-valued function of a real
number, meaning that it takes numbers as inputs and
has numbers as outputs:

The operator D, however, is not defined on

individual numbers. It is only defined on
functions:

Because the output of D is a function, the

output of D can be evaluated at a point.
For instance, when D is applied to the
squaring function,

D outputs the doubling function,

which we named ƒ(x). This
output function can then be
evaluated to get ƒ(1) =
2, ƒ(2) = 4, and so on.

Higher derivatives
Let ƒ be a differentiable
function, and let f′(x) be its
derivative. The derivative of f′
(x) (if it has one) is written f′′
(x) and is called the second
derivative of ƒ. Similarly, the
derivative of a second
derivative, if it exists, is
written f′′′(x) and is called
the third derivative of ƒ.
These repeated derivatives are
called higher-order derivatives.

If x(t) represents the position of

an object at time t, then the
higher-order derivatives
of x have physical
interpretations. The second
derivative ofx is the derivative
of x′(t), the velocity, and by
definition this is the
object's acceleration. The third
derivative of x is defined to be
the jerk, and the fourth
derivative is defined to be
the jounce.

A function ƒ need not have a

derivative, for example, if it is
not continuous. Similarly, even
if ƒ does have a derivative, it
may not have a second
derivative. For example, let

Calculation shows
that ƒ is a differentiable
function whose derivative
is

f′(x) is twice the

absolute value
function, and it
does not have a
derivative at zero.
Similar examples
show that a
function can
have kderivatives
for any non-
negative
integer k but no (k
+ 1)-order
derivative. A
function that
has k successive
derivatives is
called k times
differentiable. If in
addition the kth
derivative is
continuous, then
the function is said
to be
of differentiability
class Ck. (This is a
stronger condition
than
having k derivatives
. For an example,
see differentiability
class.) A function
that has infinitely
many derivatives is
calledinfinitely
differentiable or s
mooth.

On the real line,

every polynomial
function is infinitely
differentiable. By
standard differentia
tion rules, if a
polynomial of
degree n is
differentiated n time
s, then it becomes
a constant function.
All of its
subsequent
derivatives are
identically zero. In
particular, they
exist, so
polynomials are
smooth functions.
The derivatives of a
function ƒ at a
point x provide
polynomial
approximations to
that function near x.
For example, if ƒ is
twice differentiable,
then

in the sense
that

If ƒ is
infinitely
different
iable,
then this
is the
beginnin
g of
the Tayl
or
series fo
r ƒ.

Inflec
tion
point
Main
article: I
nflectio
n point
A point
where
the
second
derivativ
e of a
function
changes
sign is
called
an infle
ction
point.[6]
At an
inflectio
n point,
the
second
derivativ
e may
be zero,
as in the
case of
the
inflectio
n
point x=
0 of the
function
y=x3, or
it may
fail to
exist, as
in the
case of
the
inflectio
n
point x=
0 of the
function
y=x1/3.
At an
inflectio
n point,
a
function
switche
s from
being
a conve
x
function
to being
a conca
ve
function
or vice
versa.

Notat
ions
for
differ
entiat
ion

Main
article:
Notatio
n for
different
iation
Leibn
iz's
notati
on
Main
article:
Leibniz'
s
notation

The
notation
for
derivativ
es
introduc
ed
by Gottf
ried
Leibniz i
s one of
the
earliest.
It is still
commo
nly used
when
the
equatio
n y = ƒ(
x) is
viewed
as a
function
al
relations
hip
between
depend
ent and
indepen
dent
variable
s. Then
the first
derivativ
e is
denoted
by

an
d
w
as
on
ce
th
ou
gh
t
of
as
an
inf
ini
te
si
m
al
qu
oti
en
t.
Hi
gh
er
de
riv
ati
ve
s
ar
e
ex
pr
es
se
d
us
in
g
th
e
no
tat
io
n

for
the
nth
der
iva
tiv
e
of
y=
ƒ(x
)
(wi
th
res
pe
ct
to
x).
Th
es
e
are
ab
bre
via
tio
ns
for
mu
ltipl
e
ap
plic
ati
on
s
of
the
der
iva
tiv
e
op
era
tor.
For
ex
am
ple
,

With
Leibniz's
notation,
we can
write the
derivativ
e of y at
the
point x =
a in two
different
ways:

Leibniz's
notation
allows one to
specify the
variable for
differentiation
(in the
denominator).
This is
 especially
relevant
for partial
differentiation.
It also makes
the chain
rule easy to
remember:[7]

Lagrange's
notation
Sometimes referre
to as prime
notation,[8] one of
the most common
modern notations
for differentiation
due to Joseph-Lo
Lagrangeand use
the prime mark, s
that the derivative
a function ƒ(x) is
denoted ƒ′(x) or
simply ƒ′. Similarl
the second and th
derivatives are
denoted

  and  

To denote the num

derivatives beyon
point, some autho
Roman numerals
 in superscript, wh
others place the n
in parentheses:

  or  

The latter notation

to yield the notatio
the nth derivative
notation is most u
we wish to talk ab
derivative as bein
itself, as in this ca
notation can beco
cumbersome.

Newton's no
Main article: Newt

Newton's notation
differentiation, als
dot notation, place
the function name
a time derivative.
then

  and  

denote, respective
second derivative
to t. This notation
for time derivative
independent varia
represents time. I
in physics and in m
disciplines connec
such as differentia
the notation becom
 for high-order der
only very few deri

Euler's nota
Euler's notation u
operator D, which
function ƒ to give
derivative Df. The
is denotedD2ƒ, an
is denoted Dnƒ.

If y = ƒ(x) is a dep
then often the sub
to the D to clarify
variable x. Euler's
written

  or   ,

although this subs

when the variable
instance when thi
present in the exp

Euler's notation is
solving linear diffe

Computing

The derivative of a
principle, be comp
by considering the
computing its limit
derivatives of a fe
known, the deriva
are more easily co
obtaining derivativ
functions from sim
Derivatives
functions
Main article: Table

Most derivative co
require taking the
common functions
incomplete list giv
frequently used fu
variable and their

 Derivatives of

where r is any rea

wherever this func

= x1 / 4, then

and the derivative

for x = 0. When r
0, which is almost

 Exponential a

 Trigonometric
  Inverse trigon

Rules for fin

Main article: Diffe

In many cases, co
using differentiatio

 Constant rule

 Sum rule:

for all functions ƒ and g and all real numbers a and b.

 Product rule:

for all functions ƒ and g.

 Quotient rule:

for all functions ƒ and g where g ≠ 0.

 Chain rule: If
Example com
The derivative of

is

Here the second t

ln(x) and exp(x) =

Derivatives

See also: Vector c

Derivatives
A vector-valued fu
coordinate functio
are real valued fu
whose coordinate

Equivalently,

if the limit exists. T

function.

If e1, …, en is the s
the linearity prope
because each of t

This generalizatio

Partial deriv
Main article: Parti

Suppose that ƒ is

ƒ can be reinterpr

In other words, ev

Once a value of x

In this expression

The above proced

This is the partial

In general, the pa

In the above differ

and, by definition,
In other words, th
derivatives.

An important exam
variable xj. At the

This vector is calle

Directional d
Main article: Direc

If ƒ is a real-value
and the y direction

The directional d

In some cases it m
this works, suppo

This is λ times the

Because of this re

If all the partial de

This is a consequ
 The same definitio

The total der

Main article: Total

When ƒ is a funct
the behavior of ƒ.

Just like the single-variable derivative, ƒ ′(a) is chosen so that the error in this approximation is as small as
possible.

If n and m are both one, then the derivative ƒ ′(a) is a number and the expression ƒ ′(a)v is the product of two
numbers. But in higher dimensions, it is impossible for ƒ ′(a) to be a number. If it were a number, then ƒ ′
(a)v would be a vector in Rn while the other terms would be vectors in Rm, and therefore the formula would not
make sense. For the linear approximation formula to make sense, ƒ ′(a) must be a function that sends vectors
in Rn to vectors in Rm, and ƒ ′(a)v must denote this function evaluated at v.

To determine what kind of function it is, notice that the linear approximation formula can be rewritten as

Notice that if we c
get

If we assume that
with v + wsubstitu

hen, after adding an appropriate error term, all of the above approximate equalities can be rephrased as inequalities. In

e vector space: The numerator lies in the codomain Rm while the denominator lies in the domain Rn. Furthermore, the derivative is
ive of ƒ at a is the unique number ƒ ′(a) such that
obian matrix of ƒ at a:

(a + h) − ƒ(a) − ƒ ′(a)h is approximately zero, in other words that

he tangent bundle of the target.

nformation, such as concavity, which cannot be described in terms of linear data such as vectors. It cannot be a function on the
n between the total derivative and the partial derivatives of a function is paralleled in the relation between the kth order jet of a
 function is obtained by replacing real variables with complex variables in the definition. If C is identified with R² by writing a
in general: the complex derivative only exists if the real derivative is complex linear and this imposes relations between the

called its tangent space: the prototypical example is a smooth surface inR³. The derivative (or differential) of a (differentiable)
t bundles of M and N. This definition is fundamental in differential geometry and has many uses — see pushforward

he Gâteaux derivative, and of the differential, called the Fréchet derivative.

ny other functions can be differentiated using a concept known as the weak derivative. The idea is to embed the continuous

ol 1969, and Spivak 1994.

m 17.8

x. Others define "dx" as an independent variable, and define du bydu = dx•ƒ′ (x). In non-standard analysis du is defined as an
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