Derivative securities are a type of security where the price depends on or derives from (get it??) an underlying asset, such as commodities, currencies, interest rates, stocks, bonds and market indexes
Derivatives can be traded over-the-counter or as an exchange. OTC derivatives are more common and they’re unregulated. Derivatives traded on exchanges are regulated. And as such, OTC derivatives are riskier than standardized derivatives.
Derivatives were originally used to ensure balanced exchange rates for internationally traded goods. Because of the different values of national currencies, international traders needed a way to account for these differences. Today, derivatives are based tons of different types of transactions, even ones based on the amount of rain or the number of sunny days.
There are several types of derivatives and they can serve a lot of different functions depending on that type. Some derivatives can be used for hedging, speculation, or getting around exchange rate issues.
Futures contracts are probably the most common types of derivatives. A futures contract (sometimes just called “futures”) is an agreement for the sale of an asset. One would generally use a futures contract to hedge against risk during a particular period of time. It’s kind of like a bet between the two parties entering into the contract.
Another type of derivative securities are forward contracts. They are kind of similar to futures contracts except that forward contracts (or “forwards”) are traded Over-The-Counter instead of on the exchange.
Another common type of derivative are swaps. These are used to trade loan terms. An interest rate swap can swap a variable interest rate loan for a fixed interest rate loan.
Options are another common type of derivative. Unlike with futures, with options the buyer doesn’t have to make a transaction if they don’t want to, which is why it’s referred to as optional.
A credit derivative is a loan sold to a speculator at a price lower than what it’s actually valued. Though the original lender is selling the loan for a lower price, they are still increasing their capital that they will regain from unloading the loan, which they are then free to reinvest elsewhere.
Derivative securities are kind of the wild wild west of securities.