Home > Derivative security
In finance, a derivative security or derivative is a contract that specifies the right or obligation between two parties to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event.Another way of defining a derivative is that it is a security whose value is determined (derived) from one or more other securities, commodities, or events. The value is influenced by the features of the derivative contract, which may include the timing of the contract fulfillment, the value of the underlying security or commodity, and other factors such as volatility.
The payments between the parties may be determined by the future changes of:
- the price of some other, independently traded asset in the future (e.g., a common stock)
- the level of some index (e.g., a stock index or heating-degree-days)
- the occurrence of some well-specified event (e.g., a company defaulting)
Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly.
1 Types of derivatives
Common examples of derivatives are: (with notional amount of open OTC contracts in Dec 2003 in paranthesis)
- Forwards
- Options
- Credit default option
- Exotic interest rate option
- Foreign exchange option ($5,726 billion)
- Interest rate option ($20,012 billion)
- Interest rate cap
- Stock optionA stock option is a specific type of option with a stock as the underlying instrument (the security that the value of the option is based on). Thus it is a contract to buy (known as a " call" contract) or sell (known as a " put" contract) shares of stock, ($3,186 billion)
- SwaptionA Swaption is a finanicial term meaning an option to engage in a Interest rate swap. A swap is a contract in which the parties will exchange the cash flows associated with the items they are swapping. Swaps are usually done to exchange fixed rate cash flo
- WarrantWarrant is a term with several meanings: Band: Warrant (American band) Band: Warrant (German band) Finance: Warrant (finance) Legal: Warrant (legal) Philosophy : Warrant (philosophy) Constitution: Fourth Amendment to the United States Constitution.
- SwapSwap can refer generically to the exchanging of two things. In computer science, a swap can refer to a specific algorithm Xor swap algorithm in programming or can refer to a swap partition used by operating systems. In finance a swap is an agreement to eas
- Credit default swap
- Credit Linked Note
- Currency swap ($6,371 billion)
- Foreign exchange swap and forward ($12,387 billion)
- Interest rate swapA swap is an agreement between two counterparties to exchange something (one "leg" of the swap) for something else (the other "leg"). These "things" can be anything that has a financial value, but in the financial world one leg is typically a stock or oth ($111,209 billion)
- Total return swapTotal return swap or total rate of return swap or TRORS, a contract in which one party receives interest payments on a reference asset plus any capital gains and losses over the payment period, while the other receives a specified fixed or floating cash f
Some less common, but intriguing, examples are:
- Economic derivatives which pay off according to the state of the economy as measured by national statistical agencies
- Weather derivativesWeather derivatives are financial instruments that can be used by organisations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. The difference to other derivatives is that the u
