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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)