A financial instrument is a document that has monetary value or which establishes an obligation to pay. Examples of financial instruments are cash, foreign currencies, accounts receivable, loans, bonds, equity securities, and accounts payable.
A derivative is a financial instrument that has the following characteristics:
- It is a financial instrument or a contract that requires either a small or no initial investment;
- There is at least one notional amount (the face value of a financial instrument, which is used to make calculations based on that amount) or payment provision;
- It can be settled net, which is a payment that reflects the net difference between the ending positions of the two parties; and
- Its value changes in relation to a change in an underlying, which is a variable, such as an interest rate, exchange rate, credit rating, or commodity price, that is used to determine the settlement of a derivative instrument. The value of a derivative can even change in conjunction with the weather.
Examples of derivatives include the following:
- Call option. An agreement that gives the holder the right, but not the obligation, to buy shares, bonds, commodities, or other assets at a pre-determined price within a pre-defined time period.
- Put option. An agreement that gives the holder the right, but not the obligation, to sell shares, bonds, commodities, or other assets at a pre-determined price within a pre-defined time period.
- Forward. An agreement to buy or sell an asset at a pre-determined price as of a future date. This is a highly customizable derivative, which is not traded on an exchange.
- Futures. An agreement to buy or sell an asset at a pre-determined price as of a future date. This is a standardized agreement, so that they can be more easily traded on a futures exchange.
- Swap. An agreement to exchange one security for another, with the intent of altering the security terms to which each party individually is subjected.
In essence, a derivative constitutes a bet that something will increase or decrease. A derivative can be used in two ways. Either it is a tool for avoiding risk, or it is used to speculate. In the latter case, an entity accepts risk in order to possibly earn above-average profits. Speculation using derivatives can be extremely risky, since a large adverse movement in an underlying could trigger a massive liability for the holder of a derivative.