Derivative
What is Derivative?
A derivative is a contract whose value and cash flows depend on an underlying asset, rate, index, event, or other reference, according to specified legal terms.
A derivative should always be evaluated together with the cash position, liability, or commercial exposure it modifies. Gross notional, market value, delta-equivalent exposure, collateral, potential future exposure, and stress loss answer different questions. Governance should specify permitted purposes, independent valuation, legal review, counterparty limits, liquidity reserves, and escalation when model or market inputs become unreliable.
What derivatives include
Options, futures, forwards, and swaps are major derivative forms. Underlyings can include equities, interest rates, currencies, commodities, credit, volatility, inflation, or events. Contracts may trade on exchanges or bilaterally, settle in cash or through delivery, and be cleared or uncleared. Legal classification and investor protections vary by instrument, market, counterparty, and jurisdiction.
Why they are used
Investors and businesses use derivatives to hedge risks, gain or reduce exposure, alter portfolio duration or currency, generate contingent payoffs, and manage capital efficiently. The same contract can hedge one party and represent speculation for another. Notional amount describes a reference scale, not necessarily market value, capital at risk, or maximum possible loss.
Example
An airline enters a fuel derivative that gains when fuel prices rise. The gain can offset higher operating cost, reducing budget uncertainty. If fuel prices fall, the derivative can lose while the airline benefits from cheaper fuel. Judging the contract alone would miss the hedge relationship and could mistake successful risk reduction for poor trading performance.
Valuation and exposure
Value depends on contract terms and market inputs such as underlying price, curves, volatility, correlation, time, dividends, credit, funding, and collateral. Nonlinear contracts require scenarios and sensitivities rather than one notional figure. Portfolio analysis should aggregate economic exposure across cash positions and derivatives while distinguishing gross, net, delta-adjusted, and stress exposure.
Risks and practical checklist
Derivatives introduce market, leverage, liquidity, counterparty, basis, model, collateral, funding, settlement, legal, and operational risk. Losses can exceed initial cash paid. Read the confirmation and master agreement, identify payoff, dates, exercise, settlement, margin, netting, and termination. Independently value positions, reconcile collateral, stress discontinuous moves, and ensure the hedge matches the actual risk rather than only a convenient benchmark.
Sources and further reading
- CFTC Glossary, U.S. Commodity Futures Trading Commission