A derivative is a financial contract whose value depends on changes in the value of an underlying asset.
Derivatives are designed to help traders hedge trading positions and use leverage for speculation. The value of a derivative is derived from fluctuations in the price of the underlying asset. Derivatives have been around for centuries, and were first thought to have been used in the farming industry, where one party to a contract agrees to sell goods or livestock to a counter-party who agrees to buy those goods or livestock at a specific price on a specific date. This would aid farmers and sellers to both properly manage risk and hedge against unfortunate outcomes in the future.
The market for derivatives has grown tremendously over the centuries with the industry currently being worth quadrillions of dollars. This means that derivatives are a much larger asset class than anything else available today.
Derivative contracts can either be standardized or non-standardized. Standardized derivatives are traded on futures exchanges, which obligate the parties to transact an asset at a predetermined date and price. A non-standardized derivative on the other hand, such as a forward contract, requires the parties to agree upon factors such as price and the date prior to execution.
In the beginning, derivatives were used to ensure a balanced exchange rate for internationally traded commodities. Due to the difference in value between national currencies, international traders needed a system to combat costly currency exchange rates. Nowadays, derivatives can be based on a variety of underlying assets. While they can be used for various purposes, many derivatives exhibit the following features and functions.
There exist various forms of derivatives so we will now delve into the meaning and unique purposes of each derivative type.