A derivative is a security which has its value ‘derived’ from a separate underlying asset.
Its value changes with price fluctuations in the underlying asset. The most common underlying assets include shares, bonds, commodities, currencies, interest rates and market indices.
However, derivatives do not have to be based on financial assets. For example, there are derivatives based on weather data, such as the amount of rain fall over a period of time in a particular region.
The derivative itself is a contract typically between two parties. When the value of the underlying asset goes up one party benefits; when it falls the other party gains.
Derivatives can be used for hedging, or insuring against risk on an asset. For example, at Generate we use foreign exchange forward (derivative) contracts to at least partially hedge our offshore investments from movements in their underlying currencies
Derivatives can also be used for speculation or betting on the future price of an asset.
Derivatives play a large part in financial markets. Last year the Bank for International Settlements calculated the total notional value of derivatives contracts around the world to be an astounding USD710 trillion dollars.