What is a derivative?

Derivatives are financial assets whose value is derived from another asset. Find out how investors use them with the MoneySense Glossary.

Common derivatives include:

Options: Contracts that provide the holder the right but not the obligation to buy or sell a specific financial product such as a stock, market index or ETF at a specific price on or before a certain date.
Futures: Contracts to buy or sell a specific quality and quantity of a product to be delivered to a specific location at a specific date or during a specific month. The product might be an agricultural commodity like soybeans, an energy product like crude oil, or financial products like currencies. Futures contracts are standardized and trade on exchanges.
Forwards: Forwards are similar to futures but are not standardized. Instead, these contracts are privately negotiated between buyer and seller and can only be traded “over the counter” (OTC).
Warrants: Warrants are often created by public companies when they issue stock or debt. The warrants make the new securities more attractive, granting buyers the right to buy more at a specific price. They typically expire after a few years. Many warrants are tradable.
Rights: Rights are issued to shareholders, offering them an opportunity to buy new shares in the company. Rights are similar to warrants but have a shorter life span, typically expiring after a few weeks or months.
Swaps: A swap is a contract to exchange the cash flows of two financial instruments—for example, exchanging fixed for floating interest payments, or exchanging interest payments in one currency for payments in a different currency.

How do investors use derivatives?

Derivatives are generally used for either hedging or speculation.

Hedging is a form of risk management, protecting against future price changes that affect an asset you own. For example, a farmer can use futures to lock in the future price of a crop.
Speculating with derivatives refers to buying or selling derivatives of an underlying asset you do not own. An investor might buy call options believing that the price of the underlying shares will rise above the exercise price of the options, enabling them to buy the shares for a lower price or sell the option for more than what they paid. If the stock price declines, however, the options may expire worthless.

Example: “The movie Trading Places tells the story of corrupt commodities traders who believe they have inside information about damage to Florida’s orange crop. They buy massive amounts of orange juice futures, derivatives representing contracts for future delivery of frozen orange juice, believing the price of orange juice—and orange juice futures—will soar.”

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