What is a derivative? Definition and meaning

In the world of finance, a derivative is a contract whose value is derived from the performance of an underlying entity. Derivatives are securities that are linked to other securities such as bonds or stocks, as well as currency exchange rates and real estate. Their value is completely based on the primary security they are linked to, and are therefore not worth anything in and of themselves.

The derivative’s underlying entity may be an interest rate, index or an asset, and is generally simply called the ‘underlying’.

Derivatives are used for several purposes, such as increasing exposure to price movements for speculation, hedging (insuring against price movements), or getting access to otherwise difficult-to-trade assets or markets.

What is a derivativeA derivative is a contract with at least two parties that is based on – or derived from – a specified assed. The derivative’s parties decide what that asset will be. The most common are bonds, stocks, currencies, interest rates and commodities.

According to NASDAQ’s Investing Glossary, a derivative is:

“A financial contract whose value is based on, or “derived” from, a traditional security (such as a stock or bond), an asset (such as a commodity), or a market index.”

Many types of derivatives

Below are some of the most common financial derivatives:

Forwards: known as forward contracts or simply forwards. These are non-standardized contracts between two parties to buy-sell an asset at a given future date at a price they both agree upon now.

Forward contracts may be used for speculation or hedging. However, their non-standardized nature makes them particularly ideal for hedging.

Types of derivativesThere are many different types of derivatives.

Options: contracts between two parties to buy-sell a security at a specified price. They are typically used to trade stock options, and might also be used for other types of investments. When an investor buys the right to buy an asset at a given price within a specific time frame, he or she has purchased a call option.

A put option is purchased when the investor has bought the right to sell an asset at a specific price.

Futures: these work on the same principle as options, however, the underlying security is different. Futures were initially used for buying the rights to buy-sell a commodity, but are today also used to purchase financial securities.

Swaps: these give investors the chance to exchange their securities’ benefits. One party may, for example, own a bond with a fixed rate of interest, but is in a line of business where a variable rate is preferable. He or she may enter into a swap contract with another party and thus exchange interest rates.

The majority of derivatives are traded OTC (over-the-counter), or on an exchange. The three largest derivatives exchanges are the CME Group in Chicago, Eurex in Frankfurt, and the Korea Exchange. The largest equity option exchanges are the Chicago Board of Options Exchange, Nasdaq OMX PHLX in Philadelphia, and the BM&F (Brazilian Mercantile & Futures Exchange).

Earliest derivatives

The Code of Hammurabi dated around 1792-1750 BC, has 282 laws. Below is the text of its 48th law:

“If any one owe a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not grow for lack of water; in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for the year.”

Hammurabi was a king of Babylon. He engraved the laws on stone steles (upright stone slabs). It is one of the oldest written bodies of laws we know of today, and covers nearly all the aspects of civil as well as two commercial laws at the time.

If we write the quote from the 48th law in modern English, it might read as follows, according to Steve Kummer and Christian Pauletto, from Switzerland’s State Secretariat for Economic Affairs (SECO):

“A farmer who has a mortgage on his property is required to make annual interest payments in the form of grain, however, in the event of a crop failure, this farmer has the right not to pay anything and the creditor has no alternative but to forgive the interest due. Experts in the field of derivatives would classify such a contract as a put option.”

“In other words: If the harvest is plentiful and the farmer has enough grain to pay his mortgage interest, the put option would expire worthless. If his harvest fell short, however, he would exercise his right to walk away from making the payment.”

After the collapse of the Roman Empire, contracts for future delivery continued being used in the Byzantine Empire in the eastern Mediterranean.

From Mesopotamia to Europe

Historians say that the Sephardic Jews carried derivative trading from Mesopotamia (a region in modern-day Iraq, Syria and Kuwait) to Spain during Roman times and during the first millennium AD.

After the Sephardic Jews were chased out of Spain, they took derivative trading to the Low Countries in the 16th century. From Amsterdam, trading on securities spread to England and France at the turn of the 17th to 18th century. In the early 19th century it spread from France to Germany.

Ernst Juerg Weber, from The University of Western Australia, says there is circumstantial evidence indicating that banks and bankers were at the forefront of derivative trading during the 18th and 19th centuries.

Dr. Weber, a Senior Honorary Research Fellow, says that modern textbooks in financial economics frequently misrepresent the history of derivative securities, by saying that derivatives became significant only during the last twenty-five years. This is not the case, they have been significant for considerably longer.

Quotes using the word derivative or derivatives

– “Derivatives trading should be standardized and as much as possible moved to clearinghouses,” (Paul Singer –  an American hedge fund manager, activist investor, and philanthropist).

– “The subprime disaster was a result of financial bombs – derivatives – exploding in financial institutions such as AIG and Lehman Brothers, as well as banks and financial institutions throughout the world,” (Robert Kiyosaki – financial guru behind New York Times bestseller ‘Rich Dad, Poor Dad’).

– “With the derivatives market larger than ever, we need way more regulation of Wall Street, not less,” (Adam McKay – an American film director, producer, screenwriter, comedian, and actor).

– “Derivatives in and of themselves are not evil. There’s nothing evil about how they’re traded, how they’re accounted for, and how they’re financed, like any other financial instrument, if done properly,” (James S. Chanos – an American investment manager).

– “The discussion of derivatives in the political world has become a zero sum game,” (James Andrew ‘Jim’ Himes – an American businessman and U.S. Representative for Connecticut’s 4th congressional district).

– “An unregulated derivatives market essentially gives Wall Street a way to place hidden taxes on everything in the world.” (Matthew C. ‘Matt’ Taibbi – an American author and journalist).

– “Money never seems to be interested in strengthening regulatory agencies, for example, but always in subverting them, in making them miss the danger signs in coal mines and in derivatives trading and in deep-sea oil wells,” (Thomas Carr Frank – an American political analyst, historian, journalist and columnist for Harper’s Magazine).

Derivative – non-financial meanings

The concept of derivative is at the core of modern mathematics and Calculus.

In linguistics it is a form of a word made or developed from another form, as in: “Detestable is a derivative of detest.”

In chemistry it can mean a substance that is made from another substance. For example, trichlormethane (chloroform) is a derivative of methane.

It can also mean based on, influenced by, or originating from, as in: “Charles Darwin’s work is derivative of the moral philosophers.”

Video – What are derivatives?

In this MoneyWeek video, Tim Bennett explains what derivatives are and how we can use them to our advantage.