Derivative
A financial contract whose value is derived from an underlying asset, rate, or index.
What is Derivative?
A derivative is a financial contract between two or more parties whose value depends on the price of an underlying asset, rate, or index. Common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. The four main types of derivatives are futures, forwards, options, and swaps. Derivatives are used for two primary purposes: hedging — reducing existing exposure to price movements — and speculation, where traders take on risk to profit from expected price changes. They are traded on organized exchanges (like the CME) or privately as over-the-counter (OTC) contracts.
Example
An airline buys crude oil futures contracts to lock in fuel costs six months ahead. If oil prices rise, the futures gain in value, offsetting higher fuel bills. If prices fall, the airline loses on the futures but pays less for fuel. The derivative did not eliminate price exposure but converted it from uncertain future cost into a known, budgetable one.