In more simpler form, derivatives are financial security such as an option or future whose value is derived in part from the value and characteristics of another security, the underlying asset.
It is a generic term for a variety of financial instruments. Essentially, this means you buy a promise to convey ownership of the asset, rather than the asset itself. The legal terms of a contract are much more varied and flexible than the terms of property ownership. In fact, it’s this flexibility that appeals to investors.
When a person invests in derivative, the underlying asset is usually a Commodity, Bond, Stock, or Currency. He bet that the value derived from the underlying asset will increase or decrease by a certain amount within a certain fixed period of time.
‘Futures’ and ‘Options’ are two commodity traded types of derivatives. An ‘options’ contract gives the owner the right to buy or sell an asset at a set price on or before a given date. On the other hand, the owner of a ‘futures’ contract is obligated to buy or sell the asset.
The other examples of derivatives are Warrants and Convertible bonds (similar to shares in that they are assets). But derivatives are usually contracts. Beyond this, the derivatives range is only limited by the imagination of investment banks. It is likely that any person who has funds invested, an insurance policy or a pension fund, that they are investing in, and exposed to, derivatives – wittingly or unwittingly.
Shares or bonds are financial assets where one can claim on another person or corporation; they will be usually be fairly standardised and governed by the property of securities laws in an appropriate country.
On the other hand, a contract is merely an agreement between two parties, where the contract details may not be standardised.
Derivatives securities or derivatives products are in real terms contracts rather than solid as it fairly sounds.
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