Derivatives

A derivative is a security, the value of which depends on the value of another asset. The asset in which its value depends is called the underlying asset. Derivatives are used for both hedging risk and as high risk investments.

There is a wide range of different types of derivatives available. The commonest are futures, options and warrants. Swaps are also important.

Contracts for difference are also common. They are widely used to provide derivatives of an underlying number that can not itself be directly traded (index values, weather etc.) and to provide access to derivatives for retail investors.

Derivatives are used for hedging by buying a derivative with a value that moves against that of another investment that an investor holds. For example, shares in a given company can be hedged by buying put options in the same company.

As speculative investments, derivatives allow investors to:

  • Make a greater gain (or loss!) from the same price movement than would result from buying the underlying.
  • Make a gain from a fall in the price of the underlying.
  • Arbitrage certain inconsistencies between the prices of other investments

The common types of derivatives (e.g. futures and options) are sometimes described as vanilla, while more complex types are described as exotic.

Derivatives can be embedded in other financial instruments to create securities such as structured notes.

The valuation of derivatives on balance sheets has often been a concern for investors. This has only been partially addressed by improvements to accounting standards.

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