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MyWikiBiz, Author Your Legacy — Saturday May 18, 2013

In finance, derivatives is the collective name used for a broad class of financial instruments that derive their value from other financial instruments (known as the underlying), events or conditions.

Derivatives are usually broadly categorised by the:

• relationship between the underlying and the derivative (e.g. forward, option, swap)
• type of underlying (e.g. equity derivatives, foreign exchange derivatives, interest rate derivatives or credit derivatives)
• market in which they trade (e.g., exchange traded or over-the-counter)
• pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality)

Another arbitrary distinction is between:

• vanilla derivatives (simple and more common) and
• exotic derivatives (more complicated and specialized)

There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.

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 to 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 underlying where it is not possible to trade in the underlying (e.g. weather derivatives)
• create optionality where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level)