Derivative (finance)
Also known as: derivative security, derivative contract
A derivative is a financial contract whose value is derived from the price of an underlying asset, such as a stock, bond, commodity, currency, or index. Common derivatives include options, futures, forwards, and swaps.
A derivative is a contract between two parties whose value depends on — is derived from — something else: an underlying stock, bond, commodity, currency, interest rate, or market index. The derivative itself conveys no ownership of the underlying asset; it is an agreement about that asset's future price or performance.
The major categories are options (the right, but not the obligation, to buy or sell at a set price), futures and forwards (binding agreements to transact at a set price on a future date), and swaps (agreements to exchange streams of payments, such as fixed for floating interest). A call option on a stock, for example, gains value as the stock rises above the strike price, even though the option holder owns no shares.
Investors use derivatives for two opposite purposes. Hedgers use them as insurance — a farmer locks in a crop price with futures, or a stockholder buys puts to protect against a decline. Speculators use them to bet on price movements with leverage, since a small premium or margin deposit controls a much larger position. That leverage cuts both ways: derivatives can produce outsized gains or losses relative to the money invested, and many option positions expire completely worthless. Standard listed options are also a zero-sum arrangement — the buyer's gain is the writer's loss.
The Series 65 exam tests derivatives as an investment vehicle class: know the main types, how each is used to hedge or speculate, and their risk characteristics. (Note that in AP Calculus, "derivative" means something entirely different — the instantaneous rate of change of a function.)
Key takeaways
- A derivative's value comes from an underlying asset, rate, or index — not from owning the asset itself.
- The main types are options, futures, forwards, and swaps.
- Hedgers use derivatives to reduce existing risk; speculators use them for leveraged bets on price movement.
- Leverage magnifies both gains and losses, and options can expire worthless.
- The Series 65 exam tests derivative types, uses, and risks within its investment vehicle material.