Definition of Derivative
A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset. These assets can be stocks, bonds, commodities, currencies, interest rates, or market indexes.
Examples of Derivatives:
Options: Contracts that give the right, but not the obligation, to buy or sell an asset at a predetermined price before a specific date.
Futures: Agreements to buy or sell a particular commodity or financial instrument at a pre-agreed price on a future date.
Swaps: Contracts to exchange financial instruments or cash flows between two parties to reduce risk or gain exposure to varying financial instruments.
Forwards: Customized contracts to buy or sell an asset at a set price and date without using an exchange.
Importance in Finance:
Derivatives are predominantly utilized for hedging risk or speculating on the future value of an asset. They enable risk management in financial portfolios by permitting traders to hedge their investments against price changes. Moreover, speculators can use derivatives to invest based on the direction they anticipate the underlying assets will move.
Regulations on Derivatives:
Due to the complexity and risk associated with derivatives, they are highly regulated under various financial acts and laws depending on respective countries. In the United States, derivatives fall under regulatory oversight by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). For specific details, refer to help guides like Investopedia’s Derivatives Risk Management Guide and obey federal laws as outlined in sections of the Securities Exchange Act of 1934 and Commodity Exchange Act.
