What is a Derivative (Security)?
If you watch the financial market one invest vehicle we always hear of is “derivative”. So what’s a derivative? A derivative is a security whose price is dependent upon or derived from one or more underlying assets.
A derivative itself is a contract between two or more parties and its value is determined by fluctuations in the underlying asset, which include stocks, bonds, commodities, currencies, interest rates, forward contracts, options, and market indexes. Derivatives are mostly characterized by high leverage.
Derivatives are normally used to hedge risk, however, can also be used for speculative purposes. As an example, a Japanese investor who purchases shares of an American company off of an American exchange with U.S. dollars will be exposed to exchange-rate risk while holding that stock.
To hedge the exchange-rate risk, the investor purchases currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Yen (Japanese currency).
Related Article: What is a Hedge Fund?
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