What is a derivative?
Derivatives are financial instruments that 'derive' from the value of an underlying asset. They are often used by investors as a hedge or a protection against risk. It’s speculating on the future value of something, usually an underlying asset such as stocks or bonds. If you speculate that your stocks will go down sharply, for example, you could still get some return if they do.
Where have you heard about derivatives?
Everywhere. Since the Eighties, derivatives have been big news and sometimes bad news. They were blamed as one of the causes of the global economic downturn in 2008. However, they are still used by a wide range of investors who want to try to benefit from sudden price swings.
What you need to know about derivatives...
Derivatives can be tied to the price movements of assets, such as shares, bonds, currencies and interest rates. But they can also be connected to inflation, property prices, and in some cases even the weather!
Strictly speaking, there are just three types of derivatives: futures contracts, also forward contracts, and options contracts. Futures and forwards are essentially the same, except the latter is expected to run to delivery of the asset concerned while the former is not.
A future or forward contract is an agreement to buy the asset at a set price on a set date. An option gives the right but not the obligation to do likewise.
Swaps are not technically derivatives, although are widely considered as such. They involve the exchange of financial instruments.
Contracts for difference (CFDs) have many of the properties of derivatives, in that they allow traders to take positions on an underlying asset.