What is a derivative?

Financial derivatives are so amazingly varied that it’s actually a bit misleading to call them a single ‘market’.

Think of all the things we’ve learnt so far about financial markets: about shares, currencies, commodities, indices and so on. There will be a financial derivative linked to every one.

And this is the explanation for the term ‘derivative’. These securities are derived from other assets or aspects of financial markets. We’ll take a look at the most popular ones later in this course. But it’s important to note that they are engineered securities, that means many can seem (and often are!) tricky to understand without guidance.

Many derivatives contracts are only available to institutional investors like pension and hedge funds and asset management firms. The simplest way for retail investors like you or me to buy into them is via funds set up by these institutions – products like mutual fund or an exchange-traded funds.

But even then, some knowledge of what you’re investing in is necessary because derivatives appear at the more speculative end of the risk spectrum. Misunderstanding the risks involved can have dire consequences on your portfolio.