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FUTURES

Derivatives

I am sure that you have heard of the expression “derivative” before. Your trusty dictionary will tell you that a derivative is something that is developed from something else. If you have taken a calculus course in high school or college, you may remember the term derivative as the rate of change in a variable. In the financial world, however, the first definition is closer to the truth. Derivatives are financial instruments that have been derived from other products or financial instruments. Therefore each derivative is based on a specific product or instrument known as the underlying product or instrument. For example, a certain kind of derivative based on a specific stock (known as a stock option) would have that stock as its underlying instrument (underlying stock).

Two of the most popular types of derivatives are futures and options. We will cover these two instruments in the coming chapters. If you start getting lost in the following discussion don’t worry, the concept will become clear to you by the time you finish the futures and options chapters. So read on.

The question in your mind may be: why do derivatives exist and why do people invest in them? The straight answer is that derivatives were created to perform as hedges against losses from their underlying instruments. For example, a stockholder may buy stock options with the same underlying stock in which the options are positioned to go up …