Derivatives

Derivatives have their place in the realm of advanced investing but they should not remain a mystery to the investors. The derivative derives its value from the values of other financial instruments. The stock option derives its value from a stock and therefore, it is considered a derivative. In the same way, a swap is also a derivative due to the fact that its value is derived from the interest rate indices. The underliers are values from which a derivative acquires its value.

In contrast, we may refer to the primary instruments, more commonly called cash instruments. The latter stand for instruments with values acquired directly from the markets. Examples of cash instruments are bonds, commodities, and stocks. It is not precisely shown how the cash instruments differ from the derivative instruments. However, the distinction is useful.

There are various ways to categorize the derivative instruments. One of them is to divide them into linear and non-linear. The linear derivatives have payoff diagrams that are almost linear. The opposite holds true for the non-linear derivatives. The non-linearity is due to the fact that the derivative is either an option or has one embedded into it.

Another way to classify the derivatives is by the use of the categories vanilla and exotic. The first type is simple and common, while the second refers to the more specialized and complicated derivatives. Because no rule exists distinguish among them, the difference is typically considered a matter of custom. The usage, however, varies.

Forward and future contracts, swaps, and options are the most common types of derivatives. They are contracts that may be used as an underlying asset. There are some derivatives based on weather data exist which show the number of sunny days or the amount of rain in a region.

As a way to hedge risk, the derivatives are also used as a speculative instrument.