What is a Derivative Investment?

A derivative security investment is that which is based on (derived from) the price of some other underlying asset. The underlying can be shares of stock, an index, commodities, bonds, currencies, etc.. virtually anything.

There are 2 main categories of derivatives: Linear and non-linear.

An example of a linear derivative is a Futures Contract which gives the buyer both the right AND obligation to buy the underlying (and receieve delivery of it in the case of commodities etc.) at a specified point in the future when the contract expires. The seller would have the reverse obligation. You can cover (if u bought it u can sell it back) before the contract expires.

An example of a non-linear derivative is an Option. An option is the right but NOT the obligation to buy (or sell) the underlying at a specific strike price at (or before if American-style option) a specified expiration date. A Call option is the right to buy and a Put option is the right to sell the underlying. Options are considered non-linear because their prices do not change 1:1 with the underlying but accelerate and have curvature (delta and gamma etc).

In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked—called the underlying asset— such as a share or a currency. There are many kinds of derivatives, with the most common being swaps, futures, and options. Derivatives are a form of alternative investment.

A derivative is not a stand-alone asset, since it has no value of its own. However, more common types of derivatives have been traded on markets before their expiration date as if they were assets. Among the oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.

Derivatives are usually broadly categorized by:

- the relationship between the underlying and the derivative (e.g., forward, option, swap);

- the type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives);

- the market in which they trade (e.g., exchange-traded or over-the-counter);

- their pay-off profile.

Another arbitrary distinction is between:

- vanilla derivatives (simple and more common); and

- exotic derivatives (more complicated and specialized).